4 Criterions For Capital Lease Agreement

Posted by Glenn Philips on September 24th, 2019

A Finance or Capital lease is referred to a lease agreement in which the lesser agrees to handover the ownership rights of asset to the lessee when the lease period is over. These are considered as long term agreements and non-cancellable in nature. As a result of the agreement, the asset is recorded as the lessee's property in its general ledger, making it a fixed asset. There are certain criteria for a lease to be considered as a capital lease agreement. The criteria for capital lease hinges around mainly 4 factors including ownership, purchase option, the term of the lease, and the present value of lease rentals.

Ownership

The first criteria of a capital lease agreement are ownership in which the lesser needs to agree to transfer the leased assets to the lessee when the lease agreement expires. The lease agreement, including a provision of passing the assets to the lessee at the end of the agreement, is a capital lease agreement.

Bargain Purchase Option (BPO)

If the lease agreement contains a bargain purchase option it is called a Capital Lease agreement. This provision of the lease agreement allows the lessee to purchase the leased property or asset at a price that is expected to be considerably lower than the actual value of the value.

Lease Term

For a lease to be considered as a capital lease, the leasing period should encompass at least 75% or more than the expected economic life of the leased asset, which is non-cancellable during this period. The lease term denotes that the lifespan of the asset or property to be leased must be greater than it’s already useful life period.

Present Value

This criterion of a capital lease is about the value of the asset. According to the criteria, the minimum lease payments (MLP) should be 90% or more of the fair market value of the assets at the beginning of the lease. For example, consider the Fair market value of an asset is $ 560,000 then the Present Value of Minimum Lease Payments must be equal to or more than ,400 (which is 90%), so lease agreement satisfied the MLP present value criteria.

All these above-listed capital lease criteria are mandatory conditions for capital lease financing. If a lease agreement contains any of these criteria, then the lessee should record the agreement as a capital lease. Otherwise, it will be considered as an operating lease agreement.