A capital lease is accounted for as a purchase because it so closely resembles the acquisition of the asset. An operating lease is less like a purchase and more like a rent. The lessee normally prefers to report such transactions as operating leases to reduce the amount of liabilities shown on its balance sheet. How does an accountant determine whether a contract qualifies as a capital lease or an operating lease?
In establishing reporting guidelines in this area, FASB created four specific criteria to serve as the line of demarcation between the two types of leases. Such rules set a standard that all companies must follow. If any one of these criteria is met, the lease is automatically recorded by the lessee as a capital lease. Both the asset and liability are reported as if an actual purchase took place. Not surprisingly, accountants study these criteria carefully to determine how the rules can be avoided so that each new contract is viewed as an operating lease.
Note in each of these criteria the rationale for classifying the transaction as a capital lease.
- The lease contract specifies that title to the property will be conveyed to the lessee by the end of the lease term. If legal ownership is to be transferred from lessor to lessee, the entire series of payments is simply a method devised to purchase the asset. In substance, the agreement was never intended to be a rental. From the beginning, the property was being acquired.
- The lease contract allows the lessee to buy the property at a specified time at an amount sufficiently below its expected fair value so that purchase is reasonably assured. The availability of this bargain purchase option indicates, once again, that the true intention of the contract is the conveyance of ownership. The transaction is the equivalent of a purchase if the option price is so low that purchase by the lessee can be anticipated.
- The lease contract is for a term that is equal to 75 percent or more of the estimated life of the property. This criterion is different from the first two where the transaction was just a disguised purchased. Here, the lessee will never gain ownership. However, the lease is for such an extensive portion of the asset’s life that the lessee obtains a vast majority of its utility. Although the 75 percent standard is an arbitrary benchmark, no doubt can exist that the lessee will be the primary beneficiary of the value of the property.
- The fourth criterion is too complicated to cover in an introductory textbook. The general idea is that the lessee is paying approximately the same amount as would have been charged just to buy the asset. Paying the equivalent of the purchase price (or close to it) indicates that no real difference exists between the nature of the lease transaction and an acquisition.
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Wildcat Company leased a machine from Basket Leasing Company. The lease is for 4 years. The life of the asset is 4 years. The terms of the lease require 4 payments of $100,000 at the beginning of the year, beginning on January 1, 2017. The lease is non-cancelable. Wildcat's incremental borrowing rate is 8%. Basket's earnings rate is 6%, but Wildcat does not know Basket's rate. There is an unguaranteed residual value of $10,000 at the end of year 4. The returned equipment was worth $8,500.
On the books of Wildcat, Prepare a table to amortize the Lease Payable.
Record the inception of the lease and first payment on January 1, 2017.
Record the interest payment at the end of the first year and any depreciation expense required.
Record the return of the equipment to Basket Leasing at the end of year 4.
Lease arrangement occurring when the lease term is over 75% of the useful life are recorded on the lessee?s books as a finance lease. The lease allows the lessee to capitalize the lease and depreciate the asset as if the lease would own the property. The payments are broken down in principal and interest portion as would a normal note payable.
- PV = $100,000 x (1-(1+.08)^-4)/0.10) (1.08)
- PV = $100,000 x 3.58 = $357,710 present value of lease
On the books of Wildcat, Prepare a table to amortize the Lease Payable.
| Lease | Payment Made/ Amount Received | Principal Reduction | Interest Expense / Interest Revenue Portion | Remaining Lease Balance |
| Origination | | | | $357,710 |
| 1 | $100,000 | $100,000 | $- | $257,710 |
| 2 | $100,000 | $79,383 | $20,617 | $178,326 |
| 3 | $100,000 | $85,734 | $14,266 | $92,593 |
| 4 | $100,000 | $92,593 | $7,407 | $0 |
Record the inception of the lease and first payment on January 1, 2017
| Date | Account Title and Explanation | Debit | Credit |
|---|
| January 1, 2017 | Right of Use Asset | $357,710 | |
| Lease Payable | | $357,710 |
| Record lease origination | | |
| Date | Account Title and Explanation | Debit | Credit |
|---|
| January 1, 2017 | Lease Payable | $100,000 | |
| Cash | | $100,000 |
| Record payment at lease inception | | |
Record the interest payment at the end of the first year and any depreciation expense required.
| Date | Account Title and Explanation | Debit | Credit |
|---|
| December 31, 2017 | Interest Expense | $20,617 | |
| Interest Payable | | $20,617 |
| Record accrual of interest | | |
| Date | Account Title and Explanation | Debit | Credit |
|---|
| December 31, 2017 | Depreciation Expense | $89,427 | |
| Accumulated Depreciation - Right of Use Asset | | $89,427 |
| Record payment at lease inception | | |
- $357,710 / 4 year life = $89,427
Record the return of the equipment to Basket Leasing at the end of year 4.
| Date | Account Title and Explanation | Debit | Credit |
|---|
| December 31, 2021 | Equipment | $8,500 | |
| Gain on Asset | | $8,500 |
| Record return of asset from lease | | |
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