How to Account for a Capital Lease
Learn about operating leases., Contrast an operating lease with a capital lease., Consider the criteria for a capital lease.
Step-by-Step Guide
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Step 1: Learn about operating leases.
In order to understand a capital lease, you must first understand an operating lease, as these are the two main kinds of leases.
An operating lease is a traditional lease whereby lessor (or owner of a property) transfers the right to use the property to a borrower (or lessee) for a particular period, after which it is returned.
With an operating lease, the borrower assumes no risk of ownership.An operating lease involves no ownership of the asset, and therefore, the asset does not appear on the company's balance sheet in any way.
The only important accounting for an operating lease is the rent, or lease payment, which appears on the income statement as an expense.
Operating leases are typically short compared to the life of the asset.
For example, if a piece of machinery is being leased, and the life of the machine is 25 years, an operating lease may be for five years. -
Step 2: Contrast an operating lease with a capital lease.
A capital lease is the other type of lease, and unlike an operating lease, a capital lease requires the lessee to bear some of the risks and benefits of owning the asset, even though it never actually owns the asset.
A capital lease occurs when the lessee records the asset on the balance sheet as if it owns the asset.
The lessee would then make lease payments to the lessor, and these payments consist of interest and principal repayments, just like a loan.
There are several pro's to capital leases.
Just like if the business actually owned the asset, they can choose to deduct the interest component of the lease payment each year for taxes, and can also claim depreciation each year on the asset.
That is to say, as the asset decreases in value each year, the business can benefit from this, whereas this would not be possible with an operating lease.There are cons as well.
For example, since the asset is listed on the balance sheet, this would make the company's return on assets lower.
This is because since return on assets is income as a percentage of total assets, if assets increase, the return falls (assuming income stays the same). , Under a capital lease, the lessee is essentially buying the asset from the lessor, with the lease payments functioning as a financing arrangement.
If the lease meets one of these four criteria, it must be accounted for as a capital lease:
The asset's ownership will be transferred to the lessee upon the agreement's maturation.
The lessee is given the option of purchasing the asset at a price below the market value upon the agreement's maturation.
The term of the lease agreement is greater than 75 percent of the asset's useful life.
The present value of all the future rent payments is equal to or greater than 90% of the assets market value -
Step 3: Consider the criteria for a capital lease.
Detailed Guide
In order to understand a capital lease, you must first understand an operating lease, as these are the two main kinds of leases.
An operating lease is a traditional lease whereby lessor (or owner of a property) transfers the right to use the property to a borrower (or lessee) for a particular period, after which it is returned.
With an operating lease, the borrower assumes no risk of ownership.An operating lease involves no ownership of the asset, and therefore, the asset does not appear on the company's balance sheet in any way.
The only important accounting for an operating lease is the rent, or lease payment, which appears on the income statement as an expense.
Operating leases are typically short compared to the life of the asset.
For example, if a piece of machinery is being leased, and the life of the machine is 25 years, an operating lease may be for five years.
A capital lease is the other type of lease, and unlike an operating lease, a capital lease requires the lessee to bear some of the risks and benefits of owning the asset, even though it never actually owns the asset.
A capital lease occurs when the lessee records the asset on the balance sheet as if it owns the asset.
The lessee would then make lease payments to the lessor, and these payments consist of interest and principal repayments, just like a loan.
There are several pro's to capital leases.
Just like if the business actually owned the asset, they can choose to deduct the interest component of the lease payment each year for taxes, and can also claim depreciation each year on the asset.
That is to say, as the asset decreases in value each year, the business can benefit from this, whereas this would not be possible with an operating lease.There are cons as well.
For example, since the asset is listed on the balance sheet, this would make the company's return on assets lower.
This is because since return on assets is income as a percentage of total assets, if assets increase, the return falls (assuming income stays the same). , Under a capital lease, the lessee is essentially buying the asset from the lessor, with the lease payments functioning as a financing arrangement.
If the lease meets one of these four criteria, it must be accounted for as a capital lease:
The asset's ownership will be transferred to the lessee upon the agreement's maturation.
The lessee is given the option of purchasing the asset at a price below the market value upon the agreement's maturation.
The term of the lease agreement is greater than 75 percent of the asset's useful life.
The present value of all the future rent payments is equal to or greater than 90% of the assets market value
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Nathan Ramirez
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