Definition
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.
Explanation
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.
Related Terms
Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
Moneyzine EditorNovember 6th, 2024
The income statement is a financial accounting report that demonstrates how net income, or profit, is derived from revenues. The main categories appearing on an income statement include revenues, cost of goods sold, operating expenses, non-recurring items and net income.Moneyzine EditorNovember 6th, 2024- The financial accounting term operating lease is used to describe one of several lease arrangements that a company can hold. Operating leases are used to acquire assets on a relatively short-term basis. The cost of an operating lease appears as an expense on the income statement.Moneyzine EditorNovember 6th, 2024
The term leasehold is used to describe the contractual agreement between the lessor and lessee. The leasehold agreement grants the lessee the right to use of a specific property, for a specific period of time, in return for the agreed-to payment terms.Moneyzine EditorNovember 6th, 2024
The financial accounting term leveraged lease refers to leased property that is partially financed by the lessor with money borrowed from a financial institution. In a typical leveraged lease, the lessor may finance 20 to 40% of the property's purchase price, while creditors provide funding for the balance of the property's cost.Moneyzine EditorNovember 6th, 2024
