What are Capital Lease Criteria? Definition, Criteria, And More

Definition:

This lease is the one in which the lessor can only finance the asset leased. As for the other ownership rights, they are given to the lessee. Consequently, the asset is kept in the record as the lessee’s property in the general ledger section.

This is called a fixed asset. The lessee can only take the interest percentage on the capital lease payment.

This is recorded under the expense category compared to the expense of the whole lease payment.

Criteria of Capital Lease

The four alternatives for the capital lease criteria are as follows.

  • Ownership: When the lease period ends, the asset ownership is submitted from the lessor to the lessee.
  • Lease term: The time period for lease involves a minimum of 75% of the asset’s productive life. The lease can not be canceled during this period.
  • Bargain purchase choice: The lessee can buy an asset from the hands of the lessor when the lease term is over at a cost-effective price.
  • Present value: The minimum payment of the lease has a present value of a minimal 90%. This is called the asset’s fair value at the lease’s inception.

If the lease agreement has any of the above criteria, the lessee will record it by the name of a capital lease.

If not, then the lease is titled an operating lease instead of a capital lease. The criteria mentioned above are explained in detail below.

1. Ownership

In this criteria, the lease agreement consists of a provision that states that when the lease term is over, the title is changed to ‘passed to lease’.

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For instance, suppose that a corporation has signed the lease agreement of an asset for 60 months. The useful lifespan of the asset is precisely 10 years.

The corporation agrees that the lessor will be paid monthly for the asset and the interest when the lessor supports the asset.

On the agreement lines, the lessor will give legal ownership when the agreement is over.

This legal ownership will be of the leased asset to the lessee. Therefore, this is an example of a Capital Lease and this agreement fulfills the criteria for Ownership.

2. Lease Term

The nonrefundable lease term of 75% or above the expected economic life is given as a provision from the lease agreement.

For example, a company signed a lease agreement with another company for machinery. The fair value of machinery is $17,000 whereas the economic lifespan is 5 years.

The company has leased it for 3 years. In return the other company will repay the monthly rent of $600.

The company will charge a 3% interest on a loan of $17,000. Therefore in this example, the lease term is 3 years.

The economic lifespan of the leased asset is 5 years.

This means that the lease term is lower than 75% of the lifespan of machinery. This lease will be called an operating lease.

3. Bargain Purchase Option (BPO)

The lease is a capital lease if it has a bargain purchase option. The lease agreement offers a provision to the lessee to buy the property or leased asset at a reasonably lower price than the fair value.

This criterion is known as a bargain purchase option.

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For example, two companies signed a lease agreement on 1st January 2012. The term of the agreement is 15 years.

This lease agreement has a minimum payment of the present value: of $450,000. It is also non-cancelable. The lease utilizes the use of machinery.

The machinery has a useful life of approximately 17 years. It is also valued at $460,000. In this lease agreement, a provision is given to the company to buy the assets for the price of $20,000.

This is allowed at the end of the lease agreement. This lease agreement is characterized as a capital lease agreement.

4. Present Value

The minimum lease payments (MLP) have a 90% or above Present Value. This is calculated from the fair value of the assets.

Conclusion

From the explanations mentioned above and examples, it can be understood that a capital lease is only present if the lease agreement meets any of the above criteria.

However, if it does not meet the criteria, the lease is known as an operating lease by default. This is what sets apart the capital lease from other kinds of criteria.

However, if it does not meet the criteria, the lease is known as an operating lease by default. This is what sets apart the capital lease from other kinds.