What is a capital lease?

A capital lease, referred to as a finance lease under ASC 842 and IFRS 16, is a lease that has the characteristics of an owned asset. In accounting, the lessee records the leased asset as if he or she purchased the leased asset using funding provided by the lessor.

Capital vs operating lease test

As a refresher, an operating lease functions much like a traditional lease, where the lessee pays to use an asset, but doesn’t enjoy any of the economic benefits or incur any of the risks that come with ownership.

Finance lease vs. capital lease

Why will finance leases now be referred to as capital leases? This is one of the biggest changes between the old and new lease accounting standards. The reasoning behind this change is simple; because the majority of leases will now be capitalized (with the exception of those with a term equal to or less than 12 months), the existing nomenclature of “capital lease” is no longer accurate. Hence, the new term, “finance lease.”

Capital lease criteria: how classification has changed

There isn’t much of a change in the way finance leases are treated. What’s most significant is that there are now five tests you must complete to determine the lease classification, instead of four. One additional change is that you perform these tests at lease commencement instead of when a lease is signed.

Capital vs operating lease test

Let’s walk through each test:

  • 1st test – Does the title/ownership transfer to the lessee at the end of the lease term?
  • 2nd test – Is there a bargain purchase option*?
  • 3rd test – Is the lease term commensurate with the majority of the remaining economic life of the asset?
  • 4th test – Does the present value of the sum of the lease payments substantially equal or exceed all of the fair value of the underlying asset?
  • New 5th test – Is the asset so specialized in nature that it provides no value to the lessor once the lease is complete?

If the answer is yes to any of the above criteria, then a lease meets the standards of a finance lease. The bright lines (specific thresholds) for the 3rd and 4th tests have been removed. As we learned at the 17th Annual Financial Reporting Conference (learn more about that here), it’s important to determine your own internal policy of what the threshold will be for those tests, document it, and follow it consistently.

“Strong-form” vs. “weak-form” finance leases

Here at LeaseQuery, we like to call finance leases that meet either the 1st or 2nd criterion “strong-form” capital leases and those that meet only the 3rd or 4th criterion “weak-form” capital leases.

This is an important distinction because there is one major difference between those types of leases. For finance leases that transfer ownership at the end of the lease term and those that have a bargain purchase option (strong-form finance leases), the underlying assets are depreciated over the useful life that would be assigned if the asset were owned.

For weak-form finance leases (those that meet only the 3rd or 4th criterion), the assets would be depreciated over the shorter of the useful life or the lease term. This is a subtle difference, but it obviously has profound accounting implications.

*What is a bargain purchase option?

A bargain purchase option refers to an option within the lease agreement that, at the end of the lease term, allows the lessee to buy the underlying asset at a below-market price.

What to watch out for

With the bright lines now gone, many accountants are planning on taking a portfolio approach to classifying their leases. Instead of having to test each vehicle lease individually, for instance, they plan to test the entire fleet if the leases have similar start dates, end dates, and payments.

What we’ve heard from the boards is that this approach is acceptable. However, the caveat here is that the leases need to obviously pass or obviously fail the classification tests.

Why? If the tests are close, then the law of averages may lead to misclassification. It’s possible that some of the leases are finance, others are operating, and they’re cancelling (averaging) each other out. If that’s the case, your auditors will make you go back and perform those tests on each individual lease.

Save yourself from future headaches! If there is any gray area, we recommend you take the time to test each lease individually to determine the appropriate classification.

Capital lease vs. operating lease test

Capital lease accounting example for a lessee

Now that we’ve had our refresher, let us address capital lease accounting under ASC 840 using an example.

Assume a company (lessee) signs a lease for a forklift with the following predicates:

  • Fair value of the forklift is $16,000
  • Lease term is 3 years
  • Monthly payments of $500/month paid in advance; $50 of the monthly payment is related to maintenance
  • Interest rate a bank would charge this company for a $16,000 loan over 3 years is 4%
  • Useful life of the forklift is 5 years
  • At the end of the lease term, the company can purchase the forklift for $1,000, which is the estimated fair value at the end of the lease.

Determining capital lease vs. operating lease

How do you determine if the lease is a capital lease or an operating lease? First, we need to perform the capital versus operating lease test, which is composed of four parts under the current standards. If the lease meets any of the following four criteria, then it is a capital lease:

  1. There is a title transfer at the end of the lease term
  2. The lease agreement includes a bargain purchase option
  3. The lease term is greater than or equal to 75% of the useful life of the asset
  4. The present value of the sum of the lease payments is greater than or equal to 90% of the fair value of the leased asset

There is no title transfer at lease end, so the first test for capital lease accounting is not met. There is also no bargain purchase option (since the purchase option price is the same as the fair value at lease end), so the second test for capital lease accounting is not met. The lease term is 3 years while the useful life is 5 years. 3 years is less than 75% of 5 years (3 versus 3.75), so the third test for capital lease accounting is not met.

In order to perform the fourth test, we need to calculate the present value of the minimum lease payments. This is calculated as the present value of monthly payments of $450 over 3 years at 4%. Why are we using $450 instead of the full monthly payment of $500? Well, the $50 related to maintenance is deemed an “executory cost,” which is not considered part of the minimum lease payments and as such is excluded from the present value calculation.

This gives us a present value of $15,292.65, which is greater than 90% of the fair value of the asset (90% of $16,000 is $14,400). As a result, this is a capital lease per the fourth test, and as such capital lease accounting needs to be applied.

Note:We have a blog showing how to use excel to calculate the present value of lease payments and a free present value tool that actually performs the calculation for you.

The following schedule is an image of the lease amortization schedule used to record the journal entries under capital lease accounting:

lease amortization schedule

How to record a capital lease

We now have all the information we need to record the initial journal entry: As documented above, the present value of the minimum lease payments is $15,292.65; so the initial journal entry to record the capital lease is:

Account Debit Credit
Capital Lease Asset 15,292.65
Capital Lease Liability 15,292.65

In the first month, two entries need to be recorded; one to record the payment of the lease, and the second to record depreciation expense. Because this is a “weak-form” lease, it is depreciated over the lease term of 3 years (36 months).

Account Debit Credit
Capital Lease Liability 450.00
Maintenance Expense 50.00
Cash 500.00

Note that because the first cash payment is made at the beginning of the lease term, there is no interest to be recorded. $50 of the payment is recorded as maintenance expense, while the entire remaining balance of $450 goes directly to reduce the liability. The following journal entry represents the entry for depreciation expense, which will not change throughout the lease:

Account Debit Credit
Depreciation Expense 424.80
Accumulated Depreciation 424.80

In the second month, the lessee will make the following entries to record payment on the capital lease:

Account Debit Credit
Capital Lease Liability 400.52
Interest Expense 49.48
Maintenance Expense 50.00
Cash 500.00

Note that in the second month, a portion of the payment the lessee makes goes against interest expense, a portion goes to maintenance expense to cover executory costs, while the remaining balance goes to reduce the capital lease liability. These numbers are easily obtained from the amortization schedule above.

If you liked this blog, please read our blog explaining how to account for operating leases under the new ASC 842 standard along with a full example.

We also have a guide designed to help companies transition to the new lease standard. Download your copy today:

Lease Accounting Guide

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