Capital Lease (Finance Lease)
The Financial Accounting Standards Board rules allow companies two methods to account for leases. If the agreement meets any of the following conditions, the lease should be treated as a capital lease, also known as a finance lease:
- The term of the lease exceeds 75% of the life of the asset
- There is a transfer of ownership to the lessee at the end of the lease’s term
- The agreement includes an option to purchase at a “bargain price,” which is below fair market value
- The discounted present value of the lease payments exceed 90% of the asset’s fair market value
If none of the above rules apply, the lease is classified as an operating lease.
If a lease is classified as a capital lease, then the present value of the payments is treated as debt. Capital lease obligations of a company can be found in the liabilities section of the balance sheet, while an asset is created on the balance sheet.
A capital lease allows the company to claim accelerated depreciation of the asset. It can also deduct the interest portion of the lease and flow this cost to the company’s income statement. This allows the company a tax deduction on both depreciation of the asset as well as the interest portion of the lease.
Payments associated with operating leases are simply treated as an operating expense.