Capital Lease Obligations

 
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Capital lease obligations are the amount due for long-term asset lease agreements that are nearly equivalent to asset purchases.

A company can use a capital lease to effectively finance the purchase of an asset without ever technically purchasing the asset. A capital lease gives the company control over an asset for a large portion of its useful life, with all the risks and benefits attributed to ownership. Capital leases act as a form of financing because the company does not have to purchase the asset outright, but rather, makes monthly payments for the asset. A capital lease for an asset is quite similar to a consumer's car lease.

Capital lease obligations are installment payments that constitute a payment of principal plus interest for the capital lease. Capital lease obligations are listed in the liabilities section of a balance sheet while the property or asset leased is listed in the assets section of the balance sheet. The current portion of a capital lease obligation is the portion of a long-term capital lease that is due over the next year.

Under US Generally Accepted Accounting Principles (GAAP), a capital lease is essentially equivalent to a purchase by the lessee if it meets the following criteria:

  • Ownership of the asset is transferred to the lessee at the end of the lease term;
  • The lease contains a bargain purchase option to buy the equipment at less than fair market value;
  • The lease term equals or exceeds 75% of the asset's estimated useful life;
  • The present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.[1]

Examples

  • Company XYZ needs to purchase a new machine in order to create the newest, most innovative widgets on the market. Rather than purchase the machine outright, the company enters into a capital lease for 80% of the machines' known use life. The value of these lease is the company's capital lease obligation. On the company's balance sheet, the capital lease obligation is recorded as a liability while the machines are listed as assets.
  • Company XYZ needs to purchase a new building to house its new machines. Again, rather than purchasing the building, they enter a capital lease for 90% of the building's known use life. Each month, they make payments towards the principal plus interest for the capital lease; these payments are its monthly capital lease obligation.
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