For financial reporting purposes, there are two different types of leases: capital and operating. One major difference is that in capital lease accounting the asset is treated like a purchase, giving the lessee the same benefits and drawbacks of ownership. With new guidelines recently taking effect, this type of lease may now apply to many more leasing contracts.

What is a Capital Lease?

A capital lease is a contract that entitles a lessee to temporarily record an underlying asset as if they owned it. A capital lease agreement, also known as a lease-purchase agreement, also treats the lessor as the financier of the asset that the lessee is claiming ownership of.

One way to visualize a capital lease is to think of a person who pays for the cost of a car over the term of the lease. Although they don’t technically own it, they are financing its full value over time.

Capital Leasing Laws Recently Updated

What is and what is not considered a capital lease for accounting, auditing and assurance purposes is determined by the Generally Accepted Accounting Principles (GAAP). The guidelines for capital lease accounting were updated in 2016, requiring companies to capitalize all leases with contract terms more than one year when completing financial reporting. This amendment to the GAAP accounting rules went into effect on Dec. 15, 2018.

How Capital Lease Accounting Works

Capital lease accounting is approached in its own unique way. Unlike operating lease accounting, a capital lease agreement conveys ownership.

Even though a capital lease is essentially a rental agreement, the GAAP considers it to be a purchase as long as certain criteria have been met:

1. The length of the lease must be 75 percent or greater than the asset’s useful life.
2. The lease must have a bargain purchase option for a price less than market value.
3. The lessee must gain ownership after the lease period expires.
4. The present value of the lease payments must be above 90 percent of the asset’s market value.

An Example of a Capital Lease Agreement

If a company were to estimate the present value of its obligation under a capital lease to be $1,000,000, it would then record a $1,000,000 debit entry to its corresponding fixed asset account and a $1,000,000 credit entry to its capital lease liability account on its balance sheet.

Since a capital lease is a financing arrangement, the company in question must break down its periodic lease payments into interest expense based on its applicable interest rate and depreciation expense.

A company must also depreciate the leased asset, factoring in its salvage value and useful life. Then, when the leased asset is disposed of, the fixed asset can be credited and the accumulated depreciation account can be debited for the remaining balances.

Learn more about Capital Lease Accounting

GAAP’s capital lease accounting guidelines may have an effect on your company’s financial statements, influence interest expense, depreciation expense, assets and liabilities. If you would like to learn more about capital leases and capital lease agreements, ask a local accounting professional.