A capital lease, also known as a finance lease, is a common way for businesses to finance the purchase of long-term assets such as equipment, vehicles, and property. In a capital lease, the lessee (the company that will use the asset) essentially borrows the asset from the lessor (the company that owns the asset) for a fixed period of time, after which the lessee may have the option to purchase the asset outright. However, before a company can enter into a capital lease, it must meet certain criteria. In this article, we will discuss the capital lease criteria that must be met in order to classify a lease as a capital lease.
Understanding Capital Lease Criteria
Capital leases are an important financing option for businesses of all sizes. By entering into a capital lease agreement, a company can acquire a long-term asset without having to pay for it upfront, which can be particularly beneficial for small and medium-sized businesses that may not have access to significant amounts of capital. However, in order to qualify as a capital lease, a lease must meet certain criteria. These criteria help to ensure that the lease is structured in a way that is consistent with a financing arrangement, rather than a simple rental agreement.
The Ownership Transfer Test
The first criterion that must be met in order for a lease to qualify as a capital lease is the ownership transfer test. Under this test, the lease must transfer ownership of the asset to the lessee at the end of the lease term. In other words, the lessee must have the option to purchase the asset for a price that is significantly lower than its fair market value. The exact threshold for this price varies depending on the circumstances, but a common rule of thumb is that the option price must be less than 75% of the asset's fair market value. If the lease does not meet this ownership transfer test, it is not considered a capital lease and is instead classified as an operating lease.
The Bargain Purchase Option Test
The second criterion that must be met in order for a lease to qualify as a capital lease is the bargain purchase option test. Under this test, the lease must include a bargain purchase option that allows the lessee to purchase the asset at the end of the lease term for a price that is significantly lower than its fair market value. Again, the exact threshold for this price varies depending on the circumstances, but a common rule of thumb is that the purchase price must be less than 90% of the asset's fair market value. If the lease does not include a bargain purchase option, or if the purchase price is too high, the lease is not considered a capital lease and is instead classified as an operating lease.
The Lease Term Test
The third criterion that must be met in order for a lease to qualify as a capital lease is the lease term test. Under this test, the lease must have a fixed term that is at least 75% of the asset's estimated useful life. For example, if an asset has an estimated useful life of 10 years, the lease term must be at least 7.5 years. If the lease term is shorter than this, the lease is not considered a capital lease and is instead classified as an operating lease.
The Present Value Test
The fourth and final criterion that must be met in order for a lease to qualify as a capital lease is the present value test. Under this test, the present value of the lease payments must be at least 90% of the asset's fair market value. This means that the total amount of lease payments over the life of the lease must be close to the amount that the lessor would receive if they sold the asset outright at the beginning of the lease term. If the present value of the lease payments is less than 90% of the fair market value of the asset, the lease is not considered a capital lease and is instead classified as an operating lease.
Consequences of Meeting Capital Lease Criteria
If a lease meets all of the capital lease criteria, it is classified as a capital lease for accounting purposes. This means that the lessee must record the leased asset on their balance sheet as if they owned it outright. They must also record the lease payments as both a liability (representing the amount they owe the lessor) and an expense (representing the cost of using the asset). This is in contrast to operating leases, which are recorded only as an expense on the lessee's income statement.
Advantages of Capital Leases
There are several advantages to entering into a capital lease agreement. For one, it allows a company to acquire a long-term asset without having to pay for it upfront, which can be particularly beneficial for small and medium-sized businesses that may not have access to significant amounts of capital. Additionally, capital leases can provide tax benefits, as lease payments are typically tax-deductible expenses. Finally, because capital leases are structured as financing arrangements rather than simple rental agreements, they can help a company improve their balance sheet by increasing their assets and liabilities.
Conclusion
In conclusion, capital leases are an important financing option for businesses of all sizes. However, in order to qualify as a capital lease, a lease must meet certain criteria. These criteria include the ownership transfer test, the bargain purchase option test, the lease term test, and the present value test. If a lease meets all of these criteria, it is classified as a capital lease for accounting purposes, and the lessee must record the leased asset on their balance sheet as if they owned it outright. By meeting the capital lease criteria, companies can enjoy the benefits of leasing, including increased access to long-term assets and potential tax benefits, while also improving their balance sheet and financial position.
