The Internal Revenue Service, or IRS, uses four tests to determine whether to record a lease on the income statement or balance sheet. If the lease does not meet at least one of the four capitalization criteria, the lessee records it as an operating lease. Operating leases show as an expense on the income statement each month as the payment comes due. Leases meeting at least one criteria for capitalization show as a balance sheet liability.
Transfer of Ownership
According to Financial Accounting Standards Board (FASB), Financial Accounting Standard No. 13, a firm has no requirement to disclose operating leases as liabilities on its balance sheet if they meet none of the capitalization criteria. The applicable paragraphs of FAS 13, 7(a)-7(d), describe the capitalization tests.
If a lease transfers ownership of the asset to the lessee, it meets the first criteria for capitalization. For example, a firm leases a new forklift and buys it at a discounted price at lease-end. The lessee treats the lease as a purchase, recording it as a capitalized lease.
Some non-cancelable leases contain a bargain purchase option. This clause gives the lessor a right to purchase the equipment once the lease ends, at a below-market price. If a non-cancelable lease contract contains a bargain purchase option, the company must capitalize the lease according to the second lease test.
Read More: How to Calculate Capital Lease Payments
Most assets have an economic, or useful, life. The IRS determines the appropriate useful life depending on the asset type. If a lease term equates to 75 percent or greater of an asset's useful life, the lessee must record it as a capital lease. For example, a firm buys a car for $8,725. The car has a 50-month lease term and an estimated useful life of 60 months. Because the lease term spans 83.3 percent of the vehicle's useful life, the third test says the lessee must capitalize the lease.
Present Value of Lease Payments
The fourth test measures the present value of the lease payments. If the present value, or PV, of the payments equals 90 percent or more of the asset's value, you must capitalize the lease. The lessee uses his incremental borrowing rate to discount the lease payments. Continuing the car example, assume monthly payments of $200, due at month-end. The PV of the payments, using a discount rate of 1 percent per month, or an incremental borrowing rate of 12 percent, is $7,840. The car has an estimated residual value of $1,180. Discounting this back at 1 percent per month equals $715. The sum of the PV of payments and PV of the residual value equals $8,555, or 98 percent of the car's value, meaning the company capitalizes the lease.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer for online finance publications since 2011, including eHow Money, The Motley Fool, and Sapling.com. She has also edited for several online finance publications, including The Balance, Opposing Views:Money, Synonym:Money, and Zacks.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.