Capital Leases

Capital leases, sometimes known as finance leases, are a type of lease agreement in which the lessee (the user of the asset) assumes some of the risks and benefits of ownership. This type of lease is treated as an asset and a corresponding liability on the lessee’s balance sheet, making it fundamentally different from operating leases, which do not appear on the balance sheet.

Definition and Characteristics

A capital lease is a lease agreement that is similar in nature to a purchase. The Financial Accounting Standards Board (FASB) has outlined specific criteria that categorize a lease as a capital lease:

  1. Ownership Transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term.
  2. Bargain Purchase Option: The lease contains an option to purchase the asset at a bargain price at the end of the lease term.
  3. Lease Term: The term of the lease is equal to 75% or more of the estimated economic life of the asset.
  4. Present Value: The present value of the minimum lease payments amounts to at least 90% of the fair value of the leased asset.

If any of these criteria are met, the lease is classified as a capital lease. It is crucial to understand these criteria as they determine the accounting treatment of the lease.

Accounting for Capital Leases

The accounting treatment for capital leases requires that the lessee recognize both an asset and a liability on its balance sheet at the inception of the lease. The value recognized is typically the present value of the minimum lease payments. Here are the essential steps:

  1. Initial Recognition:
  2. Depreciation:
    • The leased asset is depreciated over its useful life. The depreciation method and period should be consistent with that of other owned assets. If there is a transfer of ownership at the end of the lease term, the asset is depreciated over its economic life. Otherwise, it is depreciated over the shorter of the lease term or its economic life.
  3. Interest Expense:
  4. Lease Payments:

Benefits and Drawbacks

Benefits:

  1. Control Over Asset: The lessee gets more control over the asset compared to operating leases.
  2. Tax Benefits: Depreciation of the leased asset and interest expense are tax-deductible.
  3. Balance Sheet Capitalization: Helps accurately reflect the company’s assets and liabilities, increasing transparency to investors and creditors.

Drawbacks:

  1. Complex Accounting: More complex than operating leases with the need to split lease payments between interest and principal.
  2. Impact on Financial Ratios: Can affect various financial ratios such as debt-to-equity ratio, making the company appear more leveraged.

Financial Impact

The financial implications of a capital lease include its effect on a company’s balance sheet, income statement, and cash flow statement:

Transition to ASC 842

The accounting landscape for leases changed with the introduction of ASC 842 by the FASB, effective for public companies from 2019 and non-public entities from 2020. ASC 842 supersedes the previous lease accounting standard, ASC 840. The key change under ASC 842 is that it requires nearly all leases to be recognized on the balance sheet, including operating leases, though the accounting distinction between capital (now called finance leases) and operating leases remains.

Examples of Capital Lease Structures

Consider a company that leases a piece of machinery with a fair value of $1,000,000 for ten years. The lease agreement mandates yearly payments of $120,000, and the machine’s estimated economic life is 15 years. At the end of the lease term, the company has the option to purchase the machinery at a bargain price of $50,000.

Based on this information, the lease would likely be classified as a capital lease because it meets several criteria:

  1. Bargain Purchase Option: The purchase option at the end of the lease term is at a bargain price.
  2. Lease Term: The term (10 years) is over 75% of the machine’s economic life (15 years).

Lease vs. Buy Decision

Businesses often face the decision of whether to lease or buy an asset. This decision hinges on various financial and operational considerations:

A thorough financial analysis comparing the net present value (NPV) of leasing versus buying is often conducted to aid this decision.

Capital Lease Case Studies

Case Study 1: Delta Airlines

Delta Airlines has extensively used capital leases to finance its fleet. Given the substantial cost of aircraft, leasing allows the company to utilize these high-value assets without the upfront expenditure, while also reflecting the planes as assets on the balance sheet. More information can be found on Delta Airline’s investor relations page.

Case Study 2: AT&T

AT&T has leveraged capital lease accounting for various network and infrastructure-related assets. This approach enables the company to maintain a balance sheet that better reflects its asset utilization and obligations. To learn more, visit AT&T’s investor relations page.

Conclusion

Capital leases offer a compelling option for companies that need to use high-value assets without the need to immediately purchase them. By recognizing both the asset and associated liability on the balance sheet, companies can benefit from control over the asset and potential tax advantages. However, the complexity of accounting and impact on financial ratios necessitates careful consideration. The transition to ASC 842 further underscores the importance of understanding and accurately reporting capital leases, aligning financial reporting with economic realities.