Last Updated on August 3, 2023 by Morgan Beard
You already know what a capital lease is, at least in theory. It’s a legal contract entitling someone to use an asset, such as property, for a specific time. That “someone” is a lessee who can purchase the asset for less than its market value at the end of that contract. That means the lessee legally owns the asset at a certain point. But, again, you already knew that.
But what is a capital lease in practice? How do Generally Accepted Accounting Principles (GAAP) define this agreement? What about ASC 842? In this piece, we’ll explain capital leases, how they work, how to account for them, and everything else you need to know about them.
Capital Leases, Explained
Confusion around capital leases exists because ASC 842 — we’ll tell you about that later — refers to them as finance leases. For this article, we’ll use the term capital leases but know both terms mean the same thing.
A capital lease, then, in its simplest terms, is a legally-binding, long-term, and non-cancelable agreement. It involves a lessor (the person who holds the lease of the asset) and a lessee (the person who leases the asset).
Under this agreement, the lessee has specific ownership rights. While the lessor still owns the asset during the agreement, the lessee will own the asset when that agreement finishes. Throughout the capital lease, the lessee can claim depreciation charges, a critical concept in accounting. These charges determine any wear and tear or lost value of an asset over time.
Depreciation won’t impact the price the lessee pays for the asset at the end of a capital lease because the lessee and lessor have already agreed on that price. However, it will impact how the lessee and lessor account for the asset in financial statements. We’ll explain more about this later, as well as other accounting responsibilities for both parties involved in a capital lease.
While most capital leases are for real estate, such as houses and apartments, you’ll find this type of lease for all kinds of property. That includes land, ships, aircraft, and even machinery. That’s why you’ll see the term PP&E on the lessee’s balance sheet, which stands for Property, Plant, and Equipment. (“Plant” essentially means manufacturing assets.)
Side note: We mentioned that a capital lease is non-cancelable. If it does get canceled, the lessee needs to pay for any losses that result from that cancelation.
How Does GAAP Define Capital Leases?
The above definition is only the tip of the iceberg of capital leases. Ultimately, lessors and lessees are bound by GAAP, the set of accounting standards laid down by the Financial Accounting Standards Board, or FASB. Companies in the United States that fail to follow these rules when creating financial statements will land in hot water. So what does GAAP say about capital leases?
GAAP has four conditions for these agreements. For a capital lease to be a bona fide capital lease, it must meet all the following:
- Transfer of ownership: GAAP says that once a capital lease ends, the lessor must transfer ownership of an asset to the lessee. The actual lease document must include this provision.
- Reduced ownership price: At the end of the capital lease, the lessee can purchase the asset at a reduced price below market value.
- Term of lease: The term of the capital lease should equal or exceed 75% of the expected “useful life” of the asset. Useful life means the length of time in which an asset will be profitable or economically viable.
- Lease payments: The lessee must pay the lessor periodic costs equal to or more than 90% of the fair market value (FMV) of the asset from when the capital lease starts.
It’s also important to note the difference between capital leases and operating leases since many confuse the two. Under GAAP rules, a capital lease refers to the purchase of an asset where a lessee owns that asset at the end of the lease. GAAP considers an operating lease a “true lease” in that it doesn’t provide the lessee with any ownership rights. Accounting for capital and operating leases is also completely different.
What About ASC 842?
If things weren’t complicated enough, the FASB issued a new accounting standard in December 2021 that dictates how lessees and lessors account for leases, including capital leases. The first change is that capital leases now fall under the lease classification of finance leases. So you can remove capital lease from your vocabulary. If you report under GAAP and deal with leases, you should know about this standard.
ASC 842, sometimes known as Topic 842, increases transparency in the lease process and tries to reduce any off-balance sheet activities. However, it means you have more work to do during accounting time. Under the standard, you must record the majority of your leases on the balance sheet.
Like ASC 840 that came before it, ASC 842 has a long list of criteria for determining whether your capital lease really is a finance lease or an operating lease. This, of course, will influence how you record leases on the balance sheet. Moreover, ASC 842 requires you to account for liabilities and assets from your capital lease. In this context, liabilities are the current value of lease payments, while assets are liabilities adjusted for prepaid rent, additional rent expense lease incentives, and other specific items.
You might wonder if you should account for liabilities and assets from finance leases that started before ASC 842 came into force (December 2021). The answer is no. You don’t need to adjust or remeasure past capital leases as long as you accounted for them properly via ASC 840. The only exception to this rule and will require different accounting treatment than ASC 840 is if you had any prepaid or deferred rents before ASC 842.
Accounting for Capital Leases
Now that you have a deeper understanding of capital leases and their real-world context, how do you account for them? Under GAAP rules, you need to place the right information about these leases on the right documents. Let’s start with the balance sheet.
At the start of a capital lease, the lessee and lessor should record the present value (PV) of the minimum lease payments as the value of the asset. They should also record an equal amount as the liability of the asset.
After the lessee has made payments, the asset starts to depreciate, which obviously reduces the value of the asset. This depreciation impacts the liability of the asset by reducing the lease payment minus the interest payment paid by the lessee. The depreciation and interest expense amount also reduces the lessor’s equity.
The lessor and lessee should record interest payments made on the lease on the income sheet. They should also record interest expenses, which is the discounted rate of the asset multiplied by the lease’s liability at the start of the reporting period.
As previously mentioned, the lessee and lessor also need to calculate the useful life of the asset and take into account depreciation on the income statement.
What You Need to Know About Capital Leases
Capital leases can increase taxable income and liabilities and expand a company’s total assets. However, you need to fully understand finance leases and how it works, especially when accounting for that lease under GAAP and ASC 842. Lease accounting software can make the reporting process so much easier.