What is a Capital/Finance Lease?
A capital lease, now referred to as a finance lease under ASC 842, is a lease with the characteristics of a financed purchase. Under US GAAP, a lessee records the leased asset for a finance lease as if they purchased it with funding provided by the lessor.
A lessee should record a lease as a capital/finance lease and therefore apply finance (capital) lease accounting if ANY of the following criteria are met:
- Ownership of the underlying asset transfers to the lessee after the lease term
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise (includes bargain purchase options).
- The lease term is 75% or greater than the useful life of the underlying asset
- The present value of the lease payments is at least 90% of the fair value of the asset.
- The asset is so specialized in nature it provides no value to the lessor once the lease is complete. (Only under ASC 842)
When accounting for finance leases, lessees must:
- Recognize interest on the lease liability and amortization of the ROU asset in separate line items of the income statement
- Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows
Per ASC 842, existing capital leases will not require adjustment or re-measurement upon transition, provided they were accounted for correctly under ASC 840. Therefore the accounting treatment of a finance (capital) lease beginning pre-transition will be the same as the accounting required post-transition and no transition accounting adjustments will be necessary.
However, one exception is if any deferred or prepaid rents associated with the finance (capital) lease exist at transition. Any remaining balances of deferred or prepaid rents become adjustments to the related ROU asset.
Finance lease accounting under ASC 842 - Example with LeaseGuru
Below is an example of the accounting for a finance lease beginning post-transition. For the example, let’s assume an entity leases a forklift with the following considerations:
- Fair value: $16,000
- Lease term: 3 years
- Base rent: $450 month paid in advance
- Useful life of the forklift: 5 years
- Purchase option: At the end of the lease term, the entity can purchase the forklift for $1,000, which is the estimated fair value at the end of the lease.
- Discount rate: A bank would charge the lessee 4% for a $16,200 loan over 3 years
- The entity has no plans to purchase the forklift
To account for the lease appropriately, the entity must first determine if the lease is a finance lease or an operating lease. LeaseGuru will perform or confirm the lease classification test, when all the required data is input.
The following dates were used to represent a 3-year term.
The entity inputs the lease considerations into LeaseGuru.
The payment information is input last:
After all the inputs have been added, LeaseGuru performs the capital/finance vs operating test and generates the results:
One the lease has been added, the entity can generate the amortization schedule for the lease and download it from Excel.