In a lease, the property owner (lessor) gives the right to use property to a third party (lessee) in exchange for a series of rental payments. The accounting for lease obligations is determined based on the substance of the transaction. Leases are categorized as operating or capital leases using the following four questions which are simplified from the criteria established in Statement of Financial Accounting Standards No. 13, Accounting for Leases, issued in 1976 by the Financial Accounting Standards Board (FASB):
- Does the title pass to the lessee at any time during or at the end of the lease?
- Is there an opportunity to purchase the leased item at the end of the lease term at a price so below market rate (a bargain purchase option) that the lessee is likely to take advantage of the opportunity?
- Is the term of the lease greater than or equal to 75% of the service life of the leased item?
- At the time of the agreement, is the present value of the minimum lease payments greater than or equal to 90% of the fair value of the leased item to the lessor?
If the answer to any one of these is yes, the lease is considered a capital lease because the lessee has in essence accepted the risks and benefits of ownership. A capital lease requires an asset, which must be subsequently depreciated, and a liability to be recorded based on the value of the asset on the date of the lease. The liability is usually paid off with a series of equal payments. A portion of each payment is interest, similar to the mortgage payments previously discussed.
If the questions are all answered no, the lease is considered an operating lease and recorded as lease or rent expense, an income statement account, every time a payment is made.