Capital Lease

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Description of Capital Lease. Explanation.

 

Definition Capital Lease. Description.


A Capital Lease transfers (nearly) all of the risk and rewards of the leased property to the lessee. Therefore it is considered to have the economic characteristic of asset ownership


In accounting capital leases are recorded as a purchase/sale on the balance sheet as both an asset and a related liability.


The firm can claim depreciation each year on the asset and can also deduct the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.


Since firms prefer to keep leases off the books, and sometimes prefer to defer expenses, there is a strong incentive on the part of firms to report all leases as operating leases. Consequently, in the US the Financial Accounting Standards Board has ruled that a lease should be treated as an capital lease if it meets any one of the following four conditions:

  1. The lease life exceeds 75% of the life of the asset.

  2. There is a transfer of ownership to the lessee at the end of the lease term.

  3. There is an option to purchase the asset at a "bargain price" at the end of the lease term.

  4. The present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.


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