Capital Lease Accounting and Finance Lease Accounting: A Full Example

by | Oct 8, 2019 | 31 comments

What is a capital/finance 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, for a capital lease, the lessee records the leased asset as if he or she purchased the leased asset using funding provided by the lessor.

As a refresher, an operating lease functions much like a rental agreement, where the lessee pays to use an asset but doesn’t enjoy any of the ownership economic benefits nor incur any of the risks that come with ownership.

Considering purchasing an asset for your business? Try our new lease vs buy calculator:

Lease vs Buy Calculator Excel Template

Finance lease vs. capital lease

Why will capital leases now be referred to as finance 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.”

The following is an excerpt from ASC 842: Definition of a Lease:

Under the lessee accounting model in previous GAAP, the critical determination was whether a lease was a capital lease or an operating lease because lease assets and lease liabilities were recognized only for capital leases. Under Topic 842, the critical determination is whether a contract is or contains a lease because lessees are required to recognize lease assets and lease liabilities for all leases— finance and operating—other than short-term leases (that is, if the entity elects the short-term lease recognition and measurement exemption). Topic 842 provides detailed guidance and several examples to illustrate the application of the definition of a lease to assist entities in making this critical determination.

Capital lease criteria: under ASC 840

Under ASC 840-25-1, there are 4 tests that determine whether a lease is a capital lease or an operating lease. This assessment is to be performed when the lease is signed. Many companies are familiar with these four tests so we have summarized them below.

  • 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 75% or more of the remaining economic life of the asset?
  • 4th test – Does the present value of the sum of the lease payments exceed 90% or more of the fair value of the underlying asset?

Present Value Calculator

ASC 842 provides a practical expedient that, upon transition, allows a company to keep the lease classifications for leases that began pre-transition. The FASB has indicated that companies electing this practical expedient must ensure that the accounting under ASC 840 is appropriate, as this expedient was not intended to allow accounting errors. Therefore, while ASC 842 is upon us, it is important that the lessee has a firm grasp of their lease classifications under ASC 840.

“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” finance leases and those that meet only the 3rd or 4th criterion “weak-form” finance 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 or 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.

Finance lease criteria: how classification has changed under ASC 842

There isn’t much of a change in the way finance leases are treated for lessees. What’s most significant is that there are now five tests you must complete to determine the lease classification, instead of four. Another distinction is that the lease classification is performed at lease commencement under ASC 842, instead of when a lease is signed.

ASC 842-10-25-2 provides the lease classification criteria for lessees:

“A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  3. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
  4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.”

Now, let’s walk through each test and understand some of the distinctions between ASC 840 and ASC 842.

  • 1st test – Does the title/ownership of the underlying asset transfer to the lessee at the end of the lease term?

This test is consistent under ASC 840 and ASC 842.

  • 2nd test under 842 – Does a purchase option exists and is the lessee reasonably certain to exercise the option to purchase?

In contrast to ASC 840, under ASC 842, the existence of a bargain purchase option does NOT automatically classify a lease arrangement as a finance lease.

Instead, under ASC 842, the criteria is focused on the lessee’s determination (using economic factors) of its likelihood to exercise a purchase option within the agreement. The economic factors used to evaluate this purchase option could include consideration of a bargain purchase option.

  • 3rd test – Is the lease term commensurate with the major part of the remaining economic life of the asset?
  • 4th test – Is the present value of the sum of the lease payments equal or exceed substantially all of the fair value of the underlying asset?

The bright lines (specific thresholds) for the 3rd and 4th tests have been removed under ASC 842. “Major part” and “substantially all” are not defined under ASC 842, however, ASC 842-10-55-2 provides guidance that the 75% threshold for remaining economic life of the underlying asset represents a major part and 90% threshold represents substantially all of the fair value of the underlying asset. It’s important to determine your company’s internal policy of what the threshold will be for those tests, document it, and follow it consistently. In our experience, almost all of LeaseQuery’s clients have chosen to keep the existing thresholds of 75% and 90% for continuity purposes.

  • New 5th test – Is the asset so specialized in nature that it provides no alternative use to the lessor once the lease is complete?

The 5th test was added in ASC 842. However, typically, we notice that if a lease triggers the 5th test, that it also likely had triggered one of the other “weak form” tests. This is because, for example, a shrewd landlord would factor in the future use for the asset when establishing the lease payments, and as such, typically the 4th test would be triggered.

Finance lease accounting example for a lessee

Now that we’ve had our refresher, let us address finance lease accounting under ASC 842 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 finance lease vs. operating lease under ASC 842

How do you determine if the lease is a finance lease or an operating lease? A company would need to perform the finance versus operating lease test which is composed of five parts under topic 842. If the lease meets any of the following five criteria, then it is a finance lease.

Criteria 1: There is a title transfer at the end of the lease term
There is no title transfer at lease end, so the first test for finance lease accounting is not met.

Criteria 2: The lease agreement includes a purchase option that the lessee is reasonably certain to exercise. The lessee also does not plan to exercise the purchase option, so the second test for finance lease accounting is not met.

Criteria 3: The lease term is greater than or equal to the major part of the useful life of the asset. (Note: This company has maintained the greater than or equal to 75% threshold for this test).
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 finance lease accounting is not met.

Criteria 4: The present value of the sum of the lease payments is substantially all of the fair value of the leased asset. (Note: This company has maintained the greater than or equal to 90% threshold for this test).

Criteria 5: The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

The fifth test is not applicable to this lease.

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 a non-lease component under ASC 842. The lessee should only be accounting for the portion of the payments that relate to the lease component when accounting for the lease arrangement. (Note: While the terminology has changed, the overall treatment for maintenance is consistent with accounting under ASC 840, whereby the maintenance was considered an executory cost, and therefore is not considered part of the minimum lease payments, and was therefore excluded from the present value calculation.)

Present Value Calculator

Download our free present value tool that performs the present value calculation for you. (For reference, we also have a blog that illustrates how to use Excel to calculate the present value of lease payments). Using this tool, we calculate 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). This lessee has chosen to utilize the 90% threshold to represent “substantially all” of the fair value of the asset. As a result, this lease is classified as a finance lease per the fourth test, and as such finance lease accounting needs to be applied.

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

Lease Amortization Schedule - Capital Lease Blog

How to record a finance 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 finance lease at least commencement is:

Account Debit Credit
Finance Lease Asset 15,292.65
Finance 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.

The following entries would be recorded during month-end close of the first month:

A portion of the payment the lessee makes goes against interest expense, a portion relates to the non-lease element of maintenance costs, while the remaining balance goes to reduce the finance lease liability. These numbers are easily obtained from the amortization schedule above.

Account Debit Credit
Finance Lease Liability 401.20
Interest Expense 48.80
Maintenance Expense 50.00
Cash 500.00

Because this is a “weak-form” lease, it is depreciated over the lease term of 3 years (36 months). 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

Journal entries in subsequent months will be similar to the first month entry, in that the payment will be allocated between lease liability, interest expense, and maintenance expense and depreciation expense will be recognized.

Related articles

If you enjoyed this article, consider reading the following:

Present Value Calculator

31 Comments

  1. david s

    Hi,

    Currently all our capital leases(finance) leases are booked under fixed asset and depreciate over the useful life. However, under ASC 842, if we have a finance lease only trigger the 90% payment rule but not transfer of ownership and bargain purchase option. Shall this lease be still considered fixed asset and depreciate over time? or it would just be booked under a Finance lease asset account and amortize over time? How would your software show these journal entries and classify them? Amortize or Depreciate?

    Reply
    • LeaseQuery

      Hi David –

      A lease meeting the 90% criteria could qualify as a finance lease, depending on all other facts and circumstances. Note however, under ASC 842 the threshold for this test is “substantially all” rather than exactly 90% as under ASC 840, though most of our clients choose to continue to use the 90% threshold after transition for the sake of continuity.

      Also, a lease which meets the finance classification criteria by only the 90% test would be considered a “weak-form” finance lease, and thus would be depreciated over the shorter of the lease term or the useful life of the asset.

      Finally, ASC 842 also offers some accounting relief for transition which allows a lessee to grandfather in the lease classification determined under ASC 840. Please see this article for more information on this and other practical expedients.

      Thanks for the question!

      Reply
  2. Amanda Payne

    Hi Brian,

    The way in which ST lease liability is measured can be interpreted in various ways; thus, making it an internal decision by each company. We would recommend that you follow-up with your auditors to present the support behind your assumption.

    Reply
  3. MMB

    Hi,

    I need your expert answer on this question.

    In year 2020 some of our lessor have waived of the rent fee for the premises we have rented, how this will affect the lease amortization in Year 2020? We have also terminated few premises because of pandemic, please guide me on how this will be derecognize in our books.

    Reply
    • Kiley Arnold

      2020 was a certainly very challenging year for lease accounting! Please see this blog on the relief accounting offered by the FASB and this blog for information on an amendment to IFRS 16 for COVID-19 lease concessions.

      Additionally, we have this blog which summarizes some of the other lease accounting transactions you may have encountered in 2020 including terminations, impairments and abandonments.

      Reply
  4. Amy

    What if your fixed asset in relation to a capital lease was placed in service the month before the lease agreement begins? There will always be a timing difference between the post date and the actual lease date – or despite the in service date of the fixed asset, would it be more reasonable to recognize the asset itself when the lease begins?

    Reply
    • Amanda Payne

      The lease (asset) should be recognized when ownership of the underlying asset is transferred from lessor to lessee, even if it occurs before the stated lease commencement in the contract. For more information, please refer to ASC 842-10-55-19 through ASC 842-10-55-20.

      Reply
  5. Allison

    Hello,

    Should interest expense be included as part of the conversion cost when switching to new lease standard?

    Reply
    • Kiley Arnold

      Hi,

      Thank you for the great question. When transitioning to the new lease accounting standard as it pertains to capital leases, there will be no change to their actual accounting treatment under ASC 842 and IFRS 16. Except for a name change to finance leases, you will continue to recognize both interest expense and depreciation expense on the income statement. Essentially, if you are working with a capital lease and transitioning to the new lease standard, it should be business as usual. There will be no additional cost for converting from ASC 840 to ASC 842 with respect to capital/finance leases.

      Reply
  6. LS

    Hi,

    At the end of the lease contract (if, no ownership transfer option and no renewal of contract), do we need to remove the cost of ROU assets and its Accumulated Depreciation from Balance Sheet? or just leave it in books as the NBV is Nil ?

    (as I recorded the cost of ROU and its Accumulate Depreciation in 2 separate account.)

    Thank you.

    Reply
    • Kiley Arnold

      Hi Laishia,

      At the end of the lease contract, if there is not a transfer of ownership or a renewal, you would dispose of the ROU asset since you have no longer own or control the asset.

      Thanks for reaching out!

      Reply
  7. Legna

    How do you record the Short term liability and the long term liability? do you apply the same principle as the example of Operating Leasing?

    I mean, ST Liability would be the next 12 months of financial liability reduction?

    Reply
    • Amanda Payne

      Yes, that is correct. The short term lease liability is the liability balance that will be resolved resolved in the next 12 months. – essentially calculated by summing the next 12 months of liability reduction. The long term lease liability is the liability balance that will not be resolved within the next 12 months. This can be calculated by summing the remaining balance of liability reduction after the first 12 months, or by taking the difference between the total lease liability balance and the short term lease liability balance of the current month.

      Reply
  8. Courtney

    Hi. I have a question about ASU 840. Assuming the lease has met criteria for a capital lease: When the FV is substantially less than the PV, the difference is expensed. Can the expense be amortized/allocated over the life of the lease or does it have to be expensed in the year of commencement? Can you point me to where I might find information about how/when to expense difference?

    Reply
    • Kiley Arnold

      Hi Courtney,

      You may be referring to one of the capital lease criteria under ASC 840. If the present value (PV) of the lease payments is less than 90% of the fair value (FV) of the lease asset, the lease does not meet the criteria for being a capital lease. In other words, the lease will be treated as an operating lease – sometimes referred to as “expensed”. An operating lease is referred to as “expensing the lease” because it will only be accounted for on the income statement and not capitalized, or placed on the balance sheet.

      Thanks!

      Reply
  9. Nathan

    Hi there,

    Are you able to confirm how to determine the present value of the sum of the lease payments when the lease interest rate is 0% and the company’s incremental borrowing rate is unknown.

    Thank you.

    Reply
    • Kiley Arnold

      Hi Nathan,

      When the rate implicit in the lease is unknown and unable to be calculated by the lessee, the lessee should use their incremental borrowing rate. We have this article on determining your incremental borrowing rate.

      Additionally, if the lessee is a non-public business entity, the entity is allowed to use the risk-free rate for the initial and subsequent measurement of the lease liabilities. If this policy election is to be applied, it must be applied to all leases and the entity must disclose this policy election. The risk-free rate, or the rate of return of an investment with zero risk, is to be determined based on a period that is similar to the lease term. For example, a five-year lease would use the same risk-free rate as a five-year risk-free note. You can obtain the current risk-free rate from the US treasury department website (treasury.gov). ASC 842-20-30-3 is the section of the US GAAP guidance that specifices the rate that can be used.

      Reply
  10. Jennifer

    Hi,

    There is a gap between the asset (amortization) and liability payment. I know that the gap eventually nets to zero at the end of the lease, but where does it get posted in the meantime? Is it an expense “clearing’ account?

    Reply
    • Kiley Arnold

      Hi Jennifer,

      The asset depreciation and the liability reduction are not meant to equal one another, as they are two separate entries. The asset depreciation is booked as a debit to depreciation expense and a credit to accumulated depreciation, which will be netted against the asset value. The cash paid for the lease payment is allocated between principal and interest expense, and in this example, maintenance costs. This entry will follow the amounts calculated in the amortization table until the lease liability has been reduced to zero.

      Thanks for reaching out!

      Reply
      • Diana

        Hi,

        For example, at December 2020, the leased asset got returned to lessor. How to record the the difference between the Finance Lease Asset & Finance Lease Liability for lessee?

        Thank you!

        Reply
        • Kiley Arnold

          Hi Diana,

          When you terminate a lease, any variance between the ROU asset and leaes liability is booked to the income statement. Please check out this article How to Account for Partial Terminations for a detailed discusson the calculations and journal entries: Partial Lease Terminations.

          Reply
  11. Regima

    Our Company is leasing equipment for 5 years with an option to purchase at end of the lease for $1. I didn’t find any interest rate in contract.Lease amount is let’s say $350,000 and finance charges are $70, 000. We owe $420,000 in total for 5 years. Each month we pay 7,002. I asked lendor for amortized schedule and there is none. He is treating this lease as rental payment. What will be the total cost of equipment? $350,000 or $420,000? How do I calculate interest and principal or should I book as rental payment? I am so confuse. Please help.

    Reply
    • Kiley Arnold

      Hi Regima,

      You have come to the right place! Because of the bargain purchase option you mention in your question, your company’s lease is a capital lease under ASC 840 and a finance lease under ASC 842. The value for the equipment and the lease liability is the present value of the lease payments. Our article Lease Liability Amortization Schedule: How to Calculate It in Excel will walk you through each step to calculate the present value of the payments and create a lease liability amortization table in Excel.

      If the discount rate is not stated in the lease agreement, you can use your company’s incremental borrowing rate. Our article Incremental Borrowing Rate for IFRS 16, ASC 842, and GASB 87: Discount Rates and When to Use Them provides addtional insight on determining your company’s IBR.

      Thanks for reaching out!
      LeaseQuery

      Reply
  12. JS

    Hi there, if the payments are made in advance, why is there interest on the first month’s payment?

    Reply
    • Jason Parker

      Hello JS –

      Great question. In this example, we’ve actually used a daily interest accrual; thus, we would only not accrue interest on the first day of the lease, rather than the entire first period. You’ll notice a trend in the amortization schedule going forward, in which months with more days accrue a slightly larger amount of interest.

      Let us know if you have any follow-up questions related to the daily rate method.

      Reply
  13. Angie Barton

    If a lease fails the 75% test and is capitalized should sales tax included in the payment be included in the amortization schedule or should it be expensed?

    Reply
    • Jason Parker

      Hey Angie! Thanks for reaching out.

      A lessee will not typically capitalize sales tax, as the payment amount is dependent on the sales tax rate; thus, you would book sales tax as an expense in the period incurred. The lessee only capitalizes fixed payment amounts in the amortization schedule.

      Let us know if you have any further questions.

      Reply
      • Michael Mehan

        What if you sign a lease that meets the capitalization requirement, but the leased equipment is not in service yet since it needs to be installed and tested. Do you depreciate the equipment or wait for it to be put in service?

        Reply
        • Jason Parker

          Hey Michael –

          Thanks for reaching out. You will not actually begin depreciating the leased asset until you obtain possession of the asset in its intended use. Typically, testing and installation occurs prior to the period in which the lessee has the right to use the asset in its intended use.

          If you’d like a more specific clarification here, just let us know.

          Reply
  14. Michelle Fiore

    What is the entry at the end of the lease term when ownership does transfer?
    Do you move the original ROU asset value to a fixed asset account along with the related accumulated depreciation? Or does only the end of lease purchase option amount become the asset’s acquisition cost?

    Reply
    • David Buchanan

      Hi Michelle! Thank you for your question.

      ASC 842-20-35-8 states, “A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.”

      A lease’s amortization schedule should cover the lease from the start date to the end date of the lease term. In the case of a transfer of ownership the underlying asset would no longer be a lease after the end date of the lease term, but an asset that is owned by the entity due to the title transfer or purchase option being exercised. As such, during the lease term, the asset would be depreciated over its useful life instead of the lease term itself per the guidance above, which is why the lease’s amortization schedule would not land at a zero net asset balance by the end of the lease term. Instead, there should be a remaining net asset balance at the end of the lease’s amortization schedule so that the entity can then account for that underlying asset as a fixed asset on their balance sheet and continue to depreciate it accordingly.

      Reply

Submit a Comment

Your email address will not be published.

Please complete the equation below: *