Capital Lease Obligations

When a lease agreement is finalized, there are two main parties in the agreement. Through capital lease obligation, lessees can obtain a particular asset from the lessor without purchasing the property. Generally, the capital lease obligation is for a 1 year or more. These are always the present values of all the payments made by lessee to the lessor. Read on to learn more about capital lease obligation and how you can calculate it.

What are Capital Lease Obligations?

A capital lease obligation is a contract between two parties – a lessor and a lessee. In this contract, the lessor offers a property to the lessee for usage. This means that it is a lease signed by two parties that rent a property/asset of one party to another. This type of agreement can benefit both parties. In the initial days of lease agreement, there is no legal transfer of property from one party to another. On the contrary, in accounting and economic terms, it looks like the actual transfer of property has happened. When the lessee offers payments to the lessor for the property, these payments are known as lease obligations. At the start of the lease, both the parties agree on what the lessee will pay to the lessor. Also, the time period for which the payments are made is calculated and recorded in the lease agreement. A balance sheet is also prepared that features the complete details of the lease agreement.

Qualifying Criteria for a Capital Lease

Capital lease is regarded as a long term lease in which the assets have the form of owned assets rather than leasing assets. However, not all leases fall into the category of capital lease. If, in case, any of the below mentioned characteristics are absent, the lease isn’t considered as a capital lease. Let us take a look at the qualifying criteria for a capital lease. If one or all the conditions are satisfied, then the lease is termed a capital lease.

• Property in the underlying assets is always transferred at the end of lease term from lessor to lessee.
• For capital lease, the bargain purchase option is available in the lease treatment. At the end of the lease term, the asset is always purchased at a value below the market price.
• At least 75% of an asset’s economic life is covered in the whole lease period.
• Asset’s present value is also taken into consideration. This value should be 90% of the asset’s value at inception.

For any lease to be counted as a capital lease, the lease agreement must satisfy the above conditions. Even if one of the points is satisfied, it is regarded as a capital lease. But if the lease doesn’t satisfy any of the above conditions, the lease term isn’t considered a capital lease.

Capital Lease Obligations: Example and How to calculate it?

The purchase of an asset is often considered as a capital lease. A capital lease obligation is the payment that is done by a lessee to lessor for a particular capital asset and for a specific period of time. There are two main components of the payment made by the lessee. The first component is regarded as the principal amount of the capital lease. It is always deducted from the capital lease obligation in the balance sheet. The second component is the interest that the lessee pays on the lease amount. It is the financial expense that is covered under the financial lease statements. To understand the concept better, let’s look at an example of capital lease obligation.

Example: – If a lessor ABC lends machinery to XYZ for a period of 5 years. As part of the capital lease, the lessor ABC has to pay $10,000 as a year-end payment. As already stated, the lease is of 5 years and is therefore considered as a capital lease. Before calculating the capital lease obligation, you need to first calculate the present lease value. The lessee assumes a 10% discount rate during the time of lease.

When the value for each year is calculated, the value works out to be 9,090 for first year, 8,260 for second year, 7,510 for third year, 6,830 for fourth year and 6,210 for fifth year. XYZ records $37,900 as a capital lease obligation instead of $50,000.

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