Crash Course in Accounting and Financial Statement Analysis, Second Edition

Capital versus Operating Leases

As discussed in Chapter 6, we know that there is an important difference between how capital leases (capitalized) and operating leases (expensed) are accounted for. So how do companies determine when to classify leases as capital or operating?

Any of these four criteria must be met for a lease to be capitalized by a lessee:

1. Title to a leased property/plant/equipment is expected to be transferred to a lessee at the end of the lease.

2. A bargain purchase option exists; a lessee can purchase the leased property at below fair market value during the lease.

3. The lease exceeds 75% of the asset’s estimated economic life.

4. The present value of the minimum lease payments incurred by a lessee is 90% or greater of the leased asset’s fair value.

For a lessor to capitalize a lease:

• Any of the aforementioned four criteria applicable to a lessee must be met.

• A lessor must be reasonably assured of collecting minimum lease payments from a lessee.

• A lessor’s performance is virtually complete and future costs relating to the leased asset can be reasonably estimated.

The lessor cannot capitalize a lease if the lessee recognizes it as an operating lease.