The criteria for a capital lease

A capital lease is a lease in which the lessor only finances the leased asset, and all other rights of ownership transfer to the lessee. This results in the recordation of the asset as the lessee's property in its general ledger, as a fixed asset. The lessee can only record the interest portion of a capital lease payment as expense, as opposed to the amount of the entire lease payment in the case of the more common operating lease.

The criteria for a capital lease can be any one of the following four alternatives:

  • Ownership. The ownership of the asset is shifted from the lessor to the lessee by the end of the lease period; or
  • Bargain purchase option. The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
  • Lease term. The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is noncancellable during that time); or
  • Present value. The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.

If a lease agreement contains any one of the preceding four criteria, the lessee records it as a capital lease. Otherwise, the lease is recorded as an operating lease. The recordation of these two types of leases is as follows:

  • Capital lease. The present value of all lease payments is considered to be the cost of the asset, which is recorded as a fixed asset, with an offsetting credit to a capital lease liability account. As each monthly lease payment is made to the lessor, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee also records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records.
  • Operating lease. Record each lease payment as an expense. There is no other entry.

Given the precise definition of a capital lease, the parties to a lease are usually well aware of the status of their lease arrangement before a lease is signed, and typically write the lease agreement so that the arrangement will be clearly defined as either a capital lease or operating lease.