This lease is defined as the one in which the lessor can only finance the asset which is leased. As for the other ownership rights, they are given to the lessee. Consequently, the asset is kept in the record as the property of the lessee in the section of the general ledger.
This is called a fixed asset. The interest percentage on the payment of capital lease can only be taken by the lessee. This is recorded under the category of expense as 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 reaches its end, the asset ownership is submitted from lessor to the lessee.
- Lease term: The time period for lease involves a minimum of 75% of the productive life of the asset. The lease can not be canceled during this time 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 lease has a present value of a minimal 90%. This is called the fair value of the asset at the inception of the lease.
In the event that the lease agreement has any of the above criteria, the lessee will record it by the name of a capital lease. If not, then instead of a capital lease, the lease is titled as an operating lease. The above-mentioned criteria are explained in detail below.
In this criteria, the agreement of lease consists of a provision which states that when the lease term is over, the title is changed to ‘passed to lease’.
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 for the asset on a monthly payment basis along with the interest when the asset is supported by the lessor. On the lines of the agreement, the lessor will give the legal ownership when the agreement time 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 which is 75% or above than 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 which is $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 as an operating lease.
3. Bargain Purchase Option (BPO)
The lease is known as a capital lease if it has a bargain purchase option. The agreement of the lease offers a provision to the lessee to buy the property or leased asset at a reasonably low price than the fair value. This criteria is known as a bargain purchase option.
As an 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: $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, 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.
From the above-mentioned explanations and examples, it can be understood that capital lease is only present if the agreement of lease 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 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.