Leasing equipment continues to be an attractive option for many companies compared to buying equipment outright. After going through the decision process of leasing new equipment, do you know how to account for it? The first question you should ask is “What type of lease is it?” Is it a capital lease or an operating lease? There are four criteria that will determine if it is a capital lease or operating lease. If any of these tests are met, it’s a capital lease:
- Based on the contract, ownership transfers to the lessee at the end of the contract.
- There is a bargain purchase option at the end of the lease. In other words, it is stated in the contract that you will be able to purchase the equipment for less than the estimated fair market value at the end of the term.
- The lease term is equal to or more than 75% of the estimated economic life of the asset. A four-year lease on an asset with a five-year estimated economic life, would be a capital lease.
- The present value of the lease payments equals or exceeds 90% of the fair value of the asset at lease inception.
If you determine that your lease is a capital lease, what do you do with it? First, the asset needs to be recorded on your books at its fair value, which may be stated in the contract; and the capital lease obligation should be recorded at that same initial value. As you make payments, you will reduce the liability and expense the implied interest, much like any other debt payments. You will also need to amortize the asset over its estimated useful life.
Hopefully, your business is in a position to be upgrading its equipment and this is helpful to you. While this is a summary of accounting for capital leases, there are other factors that may need to be taken into consideration when evaluating the four criteria above. In addition, the accounting requirements for all leases are changing for most private companies in 2020, which will completely rewrite how leases are accounted for.