Under the Generally Accepted Accounting Principles(GAAP) and Financial Accounting Standards Board(FASB), leases are treated as a special liability.
In general, the lease is a rental agreement between two parties. The lessor gives the lessee right to use a certain property or asset for a specific period. The lessee, in return, has to pay rental payments for using the property.
Many businesses use leases for different objectives. The most common objective of using a leasing agreement is to acquire a required asset without taking a lot of cash. The most commonly leased assets include buildings, computers, automobiles, and equipment.
In this blog, we intend to explain what capital leases are or finance leases. We will also compare different types of leases and the accounting treatment of the leases.
Any company or business has two options for acquiring the required equipment or asset. It can purchase it, or another alternative is a lease agreement.
According to the ASC 842 and IFRS 16, a capital lease or a finance lease can be defined as,
When the lessor gives the lessee a right to use a property or asset as a purchased asset, it is called a capital lease or finance lease.
In other words, the right of ownership and risks are transferred from the lessor to the lessee. The capital lease is most commonly used by a company when it wants to buy something. To support the eventual financing of the purchase, the company goes into an agreement with a lessor.
For accounting treatment, the capital leases are treated as the company’s assets and are shown in the balance sheet. The funding provided by the lessor is treated as a liability.
In the event of an agreement, the lessor will record it as the sale of property, and the lessee will record it as a purchase event.
How Does Capital Lease Work?
For a lease to be called a capital lease, certain requirements defined by FASB must be met. According to ASC 840, a lease agreement will be a capital lease if:
- The ownership is transferred from the lessor to the lessee at the end of the lease period
- The lease has a bargain purchase option entitling to purchase the asset at a price less than the market value
- The lease life is equal to or more than 75% of the asset’s useful life
- The present value of lease payments must be greater than 90% of the asset’s current market value
Later on, a 5th criterion was added by FASB through an amendment. Under ASC 842,
A lease agreement will be treated as a capital or finance lease if,
- The underlying asset is unique and holds no value to the lessor at the end of the lease period
Despite being rental agreements, the GAAP views it as an asset of the company. The capital leases can influence the company’s financial statements like liabilities, assets, interest expenses, etc.
According to the amendments made by FASB in 2016, a company must capitalize all lease agreements for more than one year.
The new regulations are effective on public companies from 2018 and on private companies from 2019 onward.
Capital Lease Vs. Operating Lease
Before we dive into the accounting treatment of capital leases, it is important to understand the difference between capital and operational lease.
Operational Lease Or Traditional Lease
The operating lease is a rental agreement giving the lessee the right to use the lessor’s property or asset for a limited time.
The main difference between operating and finance leases (capital leases) is the transfer of ownership rights and risks. The ownership rights and risks remain with the lessor in the operating lease.
Before the FASB -2016 ASC 842 amendment, the operating leases were considered off-balance-sheet financing. It implies that a leased asset’s rental payments and associated liabilities are not recorded in the balance sheet. The major benefit to companies was a low debt-to-equity ratio.
But now, the assets and liabilities resulting from the lease agreement are part of the financial statements.
The bright-line tests have been set to assess if a lease is operating or capital. The difference between the operating lease and the finance lease is exactly the same.
If any lease agreement does not meet the criteria discussed, it is probably an operating lease. The accounting treatment of an operating lease also differs from that of a capital lease.
The underlying asset is considered a rental in the operating lease, and rental payments are recorded in the income statement’s expense side.
There is no recording of an asset in the balance sheet. Besides, no depreciation is written off on leased assets.
The underlying asset is treated as an owned asset for the capital or finance lease. The lease amount is considered as funding by the lessor.
The asset is recorded at the book value, and its depreciation is written off and recorded in the income statement.
Whereas the present value of all future lease cashflows is treated as a liability, interest expense is accounted for in the income statement.
Let’s understand the capital lease by example and understand if the lease agreement meets a capital or finance lease’s criteria.
A company, XYZ, has undergone a lease agreement with a renter that is another company ABC. The underlying asset is an airplane.
According to the agreement, the airplane worth $1,200,000 will be leased to company XYZ for 6 years starting from January 1, 2020.
The jet plane’s useful life is 7 years, and the lease payment of $ 22000 must be made at every month’s beginning for the next 6 years.
No asset’s residual value will be left at the end of the lease period, and company XYZ will buy the asset from company ABC at a price less than the market value. The annual interest rate will be 12%.
We will test the lease on the capital lease criteria to determine if it is a lease agreement. Only then can we determine the accounting treatment for it.
Criteria 1: Asset Must Be Transferred From Lessor To Lessee
The transfer of an asset from the lessor to the lessee will occur at the end of the lease. So the first criteria hold.
Criteria 2: Bargain Price Options Available To Lessee
The lessor has entitled the lessee to buy the asset at a price less than market value after the lease period.
Criteria 3: Lease Life > 75% Of Asset’s Useful Life
6 years/ 7 years = 85.71%
It is greater than 75% of the asset’s useful life.
Criteria 4: Present Value Of Lease Payments > 90% Of the Asset’s Current Market Value
According to the agreement, company XYZ will make a monthly lease payment(MLP) at the beginning of each month, starting from January 1, 2020.
Monthly Interest Rate = 12%/12 = 1%
Number Of Periods= 12 X 6 =72 periods
Present value = 22000+ 22000(50.66)
Present Value = $1,136,562
The market value of the plane is $1,200,000.
$1,136,652/ $1,200,000 = 94%
The present value is greater than 90% of the market value.
Criteria 5: The Asset Should Have No Value For Lessor
According to the agreement, the asset will have no salvage or residual value at the end of the lease agreement.
From the test, it has been clear that the agreement lies under a capital lease. Let’s go through the accounting treatment of the lease.
The company will do the following accounting treatment for the capital lease.
Step 1: Initial Recording
At the beginning of the lease agreement, the present value of all lease payments will be calculated. The company will treat it as the cost of the asset.
The amount will debit from the fixed asset account, and the lease liability account will be credited. The journal entry will be:
|Jan 1, 2020||Fixed Asset Account(Airplane)||1,136,652|
|Lease Liability Account||1,136,652|
Step 2: Lease Payment
The monthly lease payment consists of a portion of interest and capital. As soon as the company receives invoices from the lessor, they will record a portion as interest expense and the remaining principal amount.
The interest expense will be debited to the expense account. The remainder value will be debited to the lease liability account, and cash or bank will be credited.
The interest for one month will be
Present value of lease payments X 1% = $11367
The journal entry will be:
|Lease Liability Account||10633|
|Bank Account/Account Payable||22000|
Step 3: Depreciation
Since the capital lease is treated as the purchase of an asset, depreciation for the asset is also recorded in every accounting period.
The value of the airplane was $1,136,652. Let’s say the company uses the straight-line method. If we divide the $1,136,652 over 72 (72 periods), the monthly depreciation will be $15,787.
The journal entry for every month will be:
|Depreciation Expense Account||15787|
|Accumulated Depreciation Account||15787|
Step 4: Disposal
The accumulated depreciation account is debited at the asset’s disposal. The net asset account is credited to balance off these accounts.
Suppose the carrying cost of the asset is different from the sale price. The difference is recorded as a capital gain or loss in that case.
Capital leasing offers many benefits to business organizations. By the mean of capital leases, they enjoy tax benefits which cannot be possible in operating leases. Whereas the amendments in the FASB leasing regulations, transparency has been promoted.
The companies are bound to show their lease agreements in the financial statements. In the past, many multinationals had leveraged the off-balance-sheet status of the leases.
We have tried comprehending a capital lease, a comparison with an operating lease, and accounting treatment for a lease agreement.