Capital LeaseDefined and How ASC 842 Affects It

Long-term assets, or more particularly, capital assets can be fairly expensive.

It’s not like you can purchase a piece of machinery at the same price as a consumer product right?

Not to mention the cost of buildings too.

That’s why for office spaces and warehouses, most businesses would rather rent than buy them.

Buying capital assets requires a huge amount of cash after all.

If you own a business that is renting some of the assets it’s using, then you’re probably already familiar with a certain contract called “lease”.

A lease is a contract in which one party grants another the right to use a certain asset (leased property) for a specified time.

For example, company A may ‘lease out’ one of its buildings to company B.

A lease is a legal contract, and as such, is enforceable.

There are usually two parties in a lease contract: the lessor, and the lessee.

The lessor is the one who grants the right to use the leased property (and is usually the owner too).

In exchange, the lessor receives compensation, usually in the form of lease payments.

On the other hand, the lessee is the one who gains the right to use the leased property for whatever purpose (usually for business operations).

In exchange, the lessee is responsible for paying the lessor a certain amount of compensation.

In a typical lease contract, the lessor/owner still retains the ownership of the leased property during and after the lease term ends.

But did you know that there’s a type of lease that has the characteristics of an asset purchase?

Where the lessee becomes the owner of the leased property?

We refer to it as a capital lease.

Capital Lease: What is it?

A capital lease is a type of lease contract in which the lessee gains the right to use an asset.

In addition, the lessee also gains ownership of the asset. As such, unlike a typical operating lease, the lessee has to record the asset in its balance sheet.

While technically, a capital lease is still a rental agreement, the GAAP views and treats it as a purchase agreement (if the lease meets certain criteria).

Essentially in a capital lease, the lessor finances the leased asset, while the lessor acquires all the other rights to the asset, including ownership.

This is the reason why we also refer to a capital lease as a finance lease.

Under a capital lease, the lessee cannot fully claim lease payments as expenses.

Rather, the lessee can only the interest portion of the lease payments as expenses.

That said, since the lessee also records the leased property in his/her balance sheet, s/he can claim depreciation expenses.

How Does a Lease Agreement Qualify as a Capital Lease?

For a lease contract to qualify as a capital lease, it must meet any one of the following criteria:

1. Lease Term: The lease term (length of the lease) must be at least 75% of the leased asset’s remaining useful life. Additionally, the lease must be non-cancellable. For example, the leased asset has a remaining useful life of 10 years. As such, the lease term must at least be 7.5 years for the lease to qualify as a capital lease.
2. Ownership of the Leased Property: The ownership of the leased asset transfers from the lessor to the lessee by the end of the lease term.
3. Bargain Purchase Option: The lease contains a bargain purchase option. A bargain purchase option allows the lessee to purchase the leased asset for a significantly lower price than the asset’s market value at the end of the lease term.
4. Present Value of Lease Payments: The present value of the minimum lease payments must be at least 90% of the leased asset’s fair value at the commencement of the lease.

The lease agreement only needs to meet one of the four criteria above. If it doesn’t meet any of the requirements, then the lease is automatically an operating lease.

Lease Accounting for Capital Leases (as a Lessee)

If a lease qualifies as a capital lease, the lessee will have to record it on his/her balance sheet.

But at what amount should the lessee record the leased asset and its corresponding lease liability?

Should it be at the original cost of the asset? Well, no. Rather, we have to compute the present value of the lease.

We do this by calculating the present value of the sum of the lease payment obligations.

After calculating the present value, we then debit the leased asset as a fixed asset and credit the lease liability.

For example, let’s say that a capital lease for a piece of equipment has a present value of $65,000.

The journal to record the capital lease should look like this:

Since a capital lease is essentially a financing agreement, the lessee will have to allocate its lease payments into interest and principal payments.

The principal payments ultimately reduce the balance of the lease liability account.

As for the interest payment, the lessee can claim them as expenses.

For example, let’s say that the above capital lease has an implicit interest rate of 4.96%, with annual lease payments of $15,000.

The first lease payment will be allocated in this manner:

Thus, the journal entry should be:

Of course, the leased asset needs to be depreciated too. Since the lessee recorded the leased asset as a fixed asset in his/her books, s/he can claim depreciation expense on it.

Calculating the depreciation of a leased asset is generally the same as with any other depreciable asset: depreciate the cost of the asset less its salvage value over its useful life.

For example, let’s say that the leased asset has a useful life of 5 years, with a salvage value of $3,000.

Assuming that straight line depreciation is used, the annual depreciation expense will be $12,400.

The journal entry to record the depreciation will then be:

ASC 842 and its Effect on Capital Leases

In February 2016, the FASB (Financial Accounting Standards Board) issues Accounting Standard Update 2016-02 (ASU 2016-02).

This update includes the anticipated new guidance for lease accounting via the releases of ASC 842 – Leases. ASC 842 supersedes the current standard for lease accounting which is ASC 840.

ASC 842 changes a lot of things when it comes to accounting for leases.

Firstly, it requires operating leases that have a term of more than one year to be reported in the balance sheet.

Next, the term “finance Leases” replaces “capital lease”. This means that we refer to all capital leases as finance leases from now on.

The reasoning behind this is simple: all leases that have a term of more than one year are now capitalized.

Thus, the term “capital lease” is no longer effective in distinguishing between leases.

That said, the effects of finance leases and capital leases on a business’s financial statements are virtually the same.

ASC 842 and the Criteria For Qualifying as a Finance Lease

ASC 842 also makes modifications in the way leases qualify as a finance lease:

(Unchanged) Ownership of the Leased Property

The ownership of the leased asset transfers from the lessor to the lessee by the end of the lease term.

This criterion is unchanged from ASC 840.

(Modified) Purchase Option

The lessee is given the option to purchase the asset at the end of the lease term.

The lessee is reasonably certain to exercise the option.

This is one of the modifications in the criteria. Under ASC 840, the existence of a bargain purchase option automatically qualifies the lease as a capital lease.

On the other hand, ASC 842 emphasizes the lessee’s intent to exercise the option. The existence of a purchase option, even if it’s a bargain purchase option, no longer automatically qualifies a lease as a finance lease.

(Modified) Lease Term

The term of the lease must be a major part of the remaining useful life of the leased asset.

However, if the commencement date of the lease falls at or near the end of the asset’s useful life, this criterion is not applicable for qualifying a lease as a finance lease.

Another modification in the criteria for qualification. ASC 840 explicitly states that the lease term must be at least 75% of the asset’s remaining useful life.

Under ASC 842 though, it is changed to “a major part”. 

This gives businesses the freedom to define what “a major part” is through internal policy. That said, “at least 75%” can still apply if the business opts to do so.

Another modification is the clause that this criterion isn’t applicable if the commencement date of the lease falls at or near the end of the asset’s useful life.

(Modified) Present Value of Lease Payments

The present value of the lease payment plus any guaranteed residual value (not reflected in the lease payments) equals or exceeds substantially the fair value of the leased asset.

Similar to the modifications made with the lease term criterion, ASC 842 removes the specific threshold for the present value of all lease payments. Instead of specifically stating “at least 90%”, ASC 872 states “equals or exceeds substantially”. The term “substantially” gives businesses the freedom to define what is substantial.

(New) Nature of the Leased Asset

The leased asset is of a specialized nature, and as such, the lessor has no alternative use for it at the end of the lease term.

ASC 842 adds a new criterion.

It applies to lease agreements that lease assets of a very specialized nature.

So much so that the lessor has no alternative use for it when the lease term ends.

Oftentimes, the asset specifically caters to the need of the lessee.

For example, a piece of specialized mining equipment that only the lessee can use.