Updated July 15, 2023
Definition of Capital Lease Criteria
A Capital lease criteria is a criteria on the basis of which a lease may be treated as capital since one of the party to the contract (i.e., lessor) who transfers his asset to another party (i.e. lessee) with all the substantial rights of ownership being transferred such that the lessee records the assets as fixed asset in his balance sheet & only records the interest portion of the lease amount as an expense in his profit & loss account
Explanation
- A lease may be treated as normally understood in a situation where a lessor (owner of the asset) leases his asset to a lessee (user of the asset) against a frequency of fixed payment of the amount. It is usually paid monthly. This is an operating lease.
- Capital lease arises where certain criteria are set by the relevant accounting standards that treat a lease as a capital lease.
- The basis of the criteria is that the purpose of buying the asset gets completed through the lessee.
- The standards identify the consumption of the asset& thus define a few rules to treat the lease as a capital lease.
- It is not just the nomenclature of a type of lease, but such classification changes the lease results.
Example of Capital Lease Criteria
Let’s say a machinery has the following features:
| Fair Value today | $45,000 |
| Economic Life of the Machinery | 7 |
| Scrap Value | NIL |
The machinery is leased out with the following terms:
| Monthly lease payments (MLP) | $950 |
| Term of lease | 5 |
| Num of periods | 60 |
| Interest Rate | 12% |
Evaluate whether the lease is a capital lease or an operating lease.
Solution:
The following calculations are relevant:
| A | Fair value | $45,000 |
| B | Present Value of MLP | $42,707 |
| C | Percentage of PV to fair value (B/A) | 95% |
| D | Economic Life of the machinery | 7 |
| E | Term of lease | 5 |
| F | Percentage of the lease term to economic Life (E/D) | 71% |
| G | Straight-line depreciation (A/D) | $6,429 |
Let’s have a look over the conditions:
| Condition | Whether Met? |
| Will the ownership get transferred to the lessee at the end of the lease term? | NO |
| Is there any bargain purchase option available in the agreement? | NO |
| Does the lease term exceed 75% of useful Life? | NO |
| Does the present value of MLP exceed 90% of the asset’s fair value today? | YES |
Explanation: The rule is that if any of the above conditions are met, the lease is termed a capital lease & accordingly, the lessee is treated as if he is the asset’s owner & the lessor is the financer of the asset. In our example, one of the conditions in the criteria set above is satisfied (i.e., present value criteria). The lease above would be treated as a capital lease.
Criteria for Capital Lease
A lease is treated as capital if the transaction fulfills any of the below criteria:
- There is the transfer of ownership after the lease term is over.
- Usually, the lessee gets the option to purchase the asset at a nominal price lower than the asset’s market price at the end of the lease term.
- The total period occupies at least 75% of the asset’s useful Life under the lease.
- The present value of the minimum lease payments approximately exceeds 90% of the asset’s fair value under the lease.
As you can see from the above conditions, the asset is useless/worthless at the end of the lease term since the lessee enjoys the economic benefits from the asset’s consumption during his lease term.
The above conditions are explained in detail as follows:
Condition 1: Ownership of The Asset
- This condition is required to be specified in the rental agreement itself.
- If any such condition is not specified in the agreement, the lessee has to physically return the asset to the lessor at the end of the lease term. This happens even if all other conditions of the capital lease are satisfied.
Condition 2: Bargain Purchase Option
- Bargain purchase option means the holder of the asset gets a right through the agreement to buy the asset at a specified discount price than the material price at the end of the lease term. The agreement may specify the amount the lessee would purchase the asset.
- The value of the transfer is substantially lower than the market price.
Condition 3: Tenure of The Lease
- This is the acid test of the lease, which clearly defines the type of lease. We are concerned with lease term only if this equals or exceeds 75% of the asset’s useful Life.
- No one would lend an asset throughout its useful Life. Thus, this clause in the agreement attracts attention.
- The asset’s economic Life can be certified by an expert or usually understood by a normal person depending on the nature of the asset.
Condition 4: Present value of MLP
- This condition is said to be satisfied only when the present value of all those payments approximates at least 90% of the asset’s fair value. The fair value of the asset refers to the fair value today.
- Such a condition defines the fact that the lessee has actually paid the full price of the asset.
Capital Lease Criteria FASB
- The criteria FASB (Financial Accounting Standards Board) set focuses on the substance over form rule. It means that the actual purpose of the event is to be looked at rather than the mere nature of the event.
- Thus, FASB amended the accounting standards in the US with the requirement to capitalize the leases with a lease term of more than one year.
- This amendment has major implications on lease-oriented companies. It requires the asset to be capitalized in the books of the lessee.
- Thus, the mere rental agreement is not the criteria to term the lease as an operating lease.
Capital Lease Criteria Asc 840 & 842
- There are a few differences in the lease classification under ASC 840 & ASC 842.
- The four criteria set above are specified in ASC 840. However, ASC 842 specifies additional criteria (i.e., fifth criteria) wherein if the asset becomes useless for the lessor at the end of the lease term, then the asset is treated as a finance lease. The fifth criteria is termed a specialized use test.
- ASC 840 specifies that minimum lease payments are to be used for recording the asset’s value in the books of the lessee. ASC 840 excludes contingent rentals and executory costs from its calculations.
- On the other hand, ASC 842 uses the term “in substance” fixed payments, meaning those payments that appear variable in nature but must be made by the lessee. Such costs include the insurance cost, taxes applicable during the lease term, and maintenance expenses to be borne by the person using the asset.
Conclusion
The accounting standard focuses on the “substance over form” principle. This means the purpose of the event is given more importance than the mere nature of the event. As understood, the capital lease transfers the substantial characteristics of ownership from one person to another & terms the transaction as a financing arrangement. The criteria set by the FASB are logical in normal understanding. The accounting standard also requires certain disclosures by the lessee in the financial statements.
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This is a guide to Capital Lease Criteria. Here we also discuss the definition and capital lease criteria of FASB, along with examples. You may also have a look at the following articles to learn more –
