what is capital lease 
a capital lease is a contract entitling a renter to the temporary use of an asset and has the economic characteristics of asset ownership for accounting purposes investopedia michela buttignolunderstanding capital leasethe capital lease requires a renter to book assets and liabilities associated with the lease if the rental contract meets specific requirements in essence a capital lease is considered a purchase of an asset while an operating lease is handled as a true lease under generally accepted accounting principles gaap a capital lease may be contrasted with an operating lease even though a capital lease is technically a sort of rental agreement gaap accounting standards view it as a purchase of assets if certain criteria are met capital leases can have an impact on companies financial statements influencing interest expense depreciation expense assets and liabilities to qualify as a capital lease a lease contract must satisfy any of the following four criteria in 2016 the financial accounting standards board fasb made an amendment to its accounting rules requiring companies to capitalize all leases with contract terms above one year on their financial statements the amendment became effective on december 15 2018 for public companies and december 15 2019 for private companies this amendement is the consequence of the observed excessive use of operating lease as off balance sheet liabilities which understates the debt level held by companies 1accounting treatments for operating and capital leases are different and can have a significant impact on businesses taxes capital leases vs operating leasesan operating lease is different in structure and accounting treatment from a capital lease an operating lease is a contract that allows for the use of an asset but does not convey any ownership rights of the asset operating leases used to be counted as off balance sheet financing meaning that a leased asset and associated liabilities of future rent payments were not included on a company s balance sheet in order to keep the debt to equity ratio low historically operating leases enabled american firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets however the practice of keeping operating leases off the balance sheet was changed when accounting standards update 2016 02 asu 842 came into effect starting dec 15 2018 for public companies and dec 15 2019 for private companies right of use assets and liabilities resulting from leases are recorded on balance sheets 1to be classified as an operating lease the lease must meet certain requirements under generally accepted accounting principles gaap that exempt it from being recorded as a capital lease companies must test for the four criteria also known as the bright line tests listed above that determine whether rental contracts must be booked as operating or capital leases if none of these conditions are met the lease can be classified as an operating lease otherwise it is likely to be a capital lease 2the internal revenue service irs may reclassify an operating lease as a capital lease to reject the lease payments as a deduction thus increasing the company s taxable income and tax liability 3accounting for capital leasesa capital lease is an example of accrual accounting s inclusion of economic events which requires a company to calculate the present value of an obligation on its financial statements for instance if a company estimated the present value of its obligation under a capital lease to be 100 000 it then records a 100 000 debit entry to the corresponding fixed asset account and a 100 000 credit entry to the capital lease liability account on its balance sheet because a capital lease is a financing arrangement a company must break down its periodic lease payments into an interest expense based on the company s applicable interest rate and depreciation expense if a company makes 1 000 in monthly lease payments and its estimated interest is 200 this produces a 1 000 credit entry to the cash account a 200 debit entry to the interest expense account and an 800 debit entry to the capital lease liability account a company must also depreciate the leased asset that factors in its salvage value and useful life for example if the above mentioned asset has a 10 year useful life and no salvage value based on the straight line basis depreciation method the company records an 833 monthly debit entry to the depreciation expense account and a credit entry to the accumulated depreciation account when the leased asset is disposed of the fixed asset is credited and the accumulated depreciation account is debited for the remaining balances 