Capital Leases

A capital lease (also called a finance lease) transfers most of the ownership benefits and risks of an asset from the lessor to the lessee. For accounting purposes, a capital lease is treated like a purchase: the lessee records an asset and a corresponding liability on the balance sheet and recognizes interest and depreciation over the lease term.

When a Lease Is Classified as a Capital (Finance) Lease

A lease is classified as a capital/finance lease if it meets any of these criteria:

• Ownership transfers to the lessee at the end of the lease.
• The lease contains a bargain purchase option (a purchase price significantly below fair value).
• The lease term covers a major part of the asset’s economic life (commonly applied as 75% or more).
• The present value of lease payments is substantially all of the asset’s fair value (commonly applied as 90% or more).

Accounting standards (ASC 842 / FASB guidance) require lessees to recognize most long-term leases on the balance sheet as a right-of-use (ROU) asset and a lease liability. Classification determines how expense is recognized over the term.

Accounting Treatment (Lessee)

Initial recognition:
* Record the ROU asset and lease liability at the present value of lease payments.

Example journal entry at lease inception (PV = $100,000):
* Debit: Right-of-use asset $100,000
* Credit: Lease liability $100,000

Subsequent accounting:
* Split each lease payment into interest expense and principal reduction of the lease liability.
* Example: $1,000 payment with $200 interest → debit interest expense $200, debit lease liability $800, credit cash $1,000.
* Depreciate the ROU asset over the useful life or the lease term (depending on circumstances).
* Example: 10-year life, no salvage → straight-line monthly depreciation ≈ $833 ($10,000/year ÷ 12).

Expense recognition:
* Finance (capital) lease: separate interest expense and amortization/depreciation.
* Operating lease (under ASC 842): single lease expense recognized generally on a straight-line basis (but ROU asset and liability still appear on the balance sheet).

Comparison with Operating Leases

• Capital/finance lease: treated like a financed purchase—asset and liability on balance sheet; interest and depreciation on the income statement.
• Operating lease (ASC 842): ROU asset and lease liability recorded on the balance sheet, but lessee typically recognizes a single lease expense over the term.
• Historically, operating leases could be kept off-balance-sheet; modern standards require most leases >1 year to be reported on the balance sheet, improving transparency of obligations.
• Classification affects financial ratios (debt-to-equity, leverage, EBITDA) and may influence covenant compliance and borrowing capacity.

Tax Treatment

• For tax purposes, the IRS may apply different rules and can reclassify leases.
• Generally:
• Finance (capital) lease: lessee can deduct interest expense portion and depreciate the asset (subject to tax rules).
• Operating lease: lessee typically deducts the lease payments as rental expense.
• Consult a tax professional for specific tax treatment and planning.

Practical Considerations

• Review lease terms for ownership transfer, purchase options, term length relative to useful life, and payment structure—these drive classification.
• Assess financial statement and covenant impacts before entering long-term leases.
• Consider negotiating purchase options, residual guarantees, or variable-payment terms with classification implications in mind.
• Ensure systems capture present-value calculations and disclosure requirements under current lease accounting standards.

Example

A company leases machinery for 10 years while the machinery’s useful life is 12 years and includes a low-price purchase option at term end. Because the term covers most of the asset’s useful life and there is a bargain purchase option, the lease would be classified as a capital/finance lease and accounted for as a financed asset purchase.

Key Takeaways

• A capital lease shifts ownership-like risks and benefits to the lessee and is treated like an asset purchase for accounting.
• Classification is determined by specific criteria (ownership transfer, bargain purchase, lease term relative to useful life, present value of payments).
• Capital leases increase reported assets and liabilities and change income statement recognition (interest + depreciation).
• Newer lease accounting rules require most long-term leases to be recognized on the balance sheet, improving transparency.