Capital lease criteria includes the following criteria 1) the ownership of the asset gets transferred to lessee at the end of the period of lease, 2) the lessee has the option to purchase the leased asset at the price below the market price of the asset at the end of the lease period, 3) that the lease period is at least 75% of the assets economic/useful life and 4) the minimum lease payment’s present value must be at least 90% of the asset’s fair value.
Capital Lease Criteria
Capital Lease is nothing but the right or Ownership of a leased asset is transferred to lessee and lessor only finances the leased assets. Below outlined criteria of the capital lease are the most common and capital lease must meet one of the criteria to call the lease agreement as a capital lease. There are numerous examples of capital lease criteria but it is impossible to provide all examples as it varies according to situations. Below outlined criteria apply to both lessor and lessee let’s discuss it in detail with example.
Top 4 Criteria for a Capital Lease
Capital Lease criteria are mainly of four types, and the lease agreement is valid only if it satisfied any of the four criteria.
#1 – Ownership
It is the first criteria of a capital lease agreement and in its Ownership of a leased asset is transferred to the lessee at the end of the lease agreement. The lease agreement includes a provision that at the end the lease term leased assets title to passed to lessee.
Let’s try to understand the Ownership lease through the below basic example.
Sterling Corporation signed a lease agreement for an asset for 60 Months with the useful life span of an asset is 10 years. Sterling Corporation agrees to pay lessor of an asset monthly lease payment with interest as an asset is financed by the lessor and as per agreement Lessor is ready to transfer the legal Ownership of a leased asset to the lessee at the end of the agreement.
So the above lease is classified as Capital Lease as lease agreement fulfilling the Ownership criteria.
#2 – Bargain Purchase Option (BPO)
If lease agreement contains a bargain purchase option the lease is called as Capital Lease. The lease agreement gives a provision to the lessee to purchase the leased assets or property at a price that is expected to be considerably less than the fair value, such criteria are called as a bargain purchase option.
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Essar limited (Lessor) and Trojan limited (Lessee) signed a leasing agreement on 1st January 2012. The term of the lease is 15 years. The lease agreement is non-cancelable and has a minimum lease payment with a present value of $450,000 and the lease involves the use of machinery that has 17 years estimated useful life and is valued at $460,000. The lease agreement provided provision to Trojan limited to purchase the assets for $20,000 at the end of the lease agreement.
So in the above example, Bargain Purchase provision in a lease agreement is provided to Trojan Limited such lease agreement is classified as a capital lease agreement.
#3 – Lease Term
If lease agreement provides a provision of Non-cancellable lease term which is equal to 75% or more than the expected economic life of the leased assets than such leasing agreement is called as Capital Lease.
So if you look at the example explained in criteria two it’s fulfilling the lease term criteria, as lease term is 15 years and life of assets is 17 years so please term is more the 75% of economic life the leased assets in the above-mentioned example.
Let’s discuss one more example.
An ABC limited signed a lease agreement with XYZ limited for Machinery which has the fair value of $17,000 and ABC limited leased it for 3 years. In return, XYZ limited will repay Monthly rent of $600 and the economic life span of machinery is 5 years, the company also charges 3% of interest over a loan of $17,000.
So in the above example lease term is 3 years, and the economic life span of the leased asset is 5 years, so the lease term is less than 75% of the assets life span, so the above lease is called as an operating lease.
#4 – Present Value
The Present Value of the minimum lease payments (MLP) is 90% or more of the fair value of the assets.
So if you take the Example in criterion two, the Fair market value of an asset is $ 460,000 and the Present Value of Minimum Lease Payments is $450,000 which is more than 90%, so lease agreement satisfied the MLP present value criteria.
Capital Lease Criteria Example
Let’s try to understand all the above-explained four criteria’s of Capital Lease through the below example.
- On December 1, 2010, Kelly Inc. a Laptop services and printing firm and entered in the lease agreement for a color copied with Xerox limited
- The lease agreement provided provision to four annual payments of $100,000 starting from December 1, 2010, the inception of the lease, and at each December 1 till four annual payments completed.
- The economic or useful life span of a copier is estimated as six years. Before deciding to lease, Kelly Inc. considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%. How should the above lease agreement to be classified?
Now we will apply the four classifications criteria.
Calculation: – PV of MLP = Lease payments multiply by Present Value**
= $100,000 *3.48685
= $348,685 < 90% of $479,079
**Present Value of an annuity due of $1: n=4, i=10%
Since none of the four classifications criteria is met, this is not a capital lease agreement it is an operating lease agreement.
Now suppose if above lease agreement provided a provision that lease term is equal to the estimated useful life of copier than the transaction must be recorded by the lessee as a capital lease since it fulfills the criteria of the non-cancellable lease term is equal to 75% or more of the expected economic life of the assets.
So from the above explanations, it is clear that capital lease exists only if the lease agreement meets any one of the above-mentioned criteria. If a lease agreement does not meet any of the above-mentioned criteria then such lease is by default called as an operating lease. The above criterion’s used to classify leases on lessee’s books.
This has been a guide to Capital Lease Criteria. Here we discuss the top four criteria of the capital lease along with step by step example and explanations. You can learn more about accounting from the following articles –