Capital Lease Agreement
A capital lease is a type of long-term lease agreement. A capital lease is recorded on the lessee’s balance sheet. This type of lease typically spans most of the useful life of the asset. In a capital lease agreement, the lessee, the party receiving the asset, assumes both the risks and benefits of ownership. Also call a capital lease a financial lease or finance lease.
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Capital Lease Treatment
According to GAAP, property leased with a capital lease agreement must be recorded on the lessee’s balance sheet. Record the leased property as an asset with a corresponding liability. Then depreciate the asset. The liability is amortized. Payments of the interest and principal are considered separate expenses on the income statement.
According to GAAP, if a lease agreement meets one or more of the following four criteria, you must treat it as a capital lease.
1. The lease agreement includes a clause stipulating that ownership of the asset automatically transfers to the lessee at the end of the lease.
2. The lease agreement includes a clause stipulating that the lessee can purchase the asset at a discounted price at the end of the lease.
3. The duration of the lease spans at least 75% of the asset’s useful life.
4. The present value of the lease payments is equal to at least 90% of the original value of the asset.
Finance Lease versus Operating Lease
There are two main differences between capital (finance) leases and operating leases.
1. With a capital lease, the lessee must record both a lease asset and a lease liability on their balance sheet. With an operating lease, this is not required.
2. With a capital lease, the lessee assumes both the risks and benefits of owning the asset. With an operating lease, the lessor retains the risks and benefits of owning the asset throughout the duration of the lease.
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