Capital Lease: What the Old Term Means Under ASC 842
A capital lease is the ASC 840 name for a lease that the lessee accounts for much like a purchase financed with debt. Under ASC 842, the same idea is called a finance lease.
You book a right-of-use asset and a lease liability. Then you expense amortization on the asset and interest on the liability. ASC 842 uses the term only in its transition guidance. But you still see it in older loan deals, old financial statements and day-to-day talk.
This page explains what the term meant, what replaced it, and how a lessee records one today. For the full classification walkthrough, see the ASC 842 lease classification guide.
Why do people still say capital lease if ASC 842 calls it a finance lease?
Habit and paperwork. Many controllers learned lease accounting under ASC 840. Loan deals signed before adoption may still define "capital lease obligations" for covenant tests. Those definitions are contract terms, so read the agreement itself rather than assuming it tracks ASC 842.
The standard settled the transition for you. Under the package of practical expedients, ASC 842-10-65-1(f)(2) says an entity need not reassess lease classification.
It adds an example: "all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases." If you elected that package, your old capital leases became finance leases on adoption.
The balances carried over too. ASC 842-10-65-1(r)(1) requires the lessee to recognize a right-of-use asset and a lease liability. It measures them at the carrying amounts of the old capital lease asset and obligation.
ASC 842-10-65-1(r)(6) then labels them finance lease balances for presentation and disclosure. The ASC 842 transition methods article covers the adoption choices in more detail.
What is the finance lease meaning under ASC 842?
Under ASC 842-10-25-2, a finance lease is one that meets at least one of five criteria at commencement. A lessee that meets none classifies the lease as an operating lease under ASC 842-10-25-3.
The economic idea is the same one behind the old capital lease. The lessee has effectively bought the asset, or most of its use, and is paying for it over time. So the books show it like financed equipment rather than rent.
One point that trips people up: "finance lease" here is the accounting classification. It is not the consumer sense of financing a car. This page does not cover tax treatment.
What were the capital lease criteria, and what are the finance lease criteria now?
ASC 840 had four capital lease tests. They were transfer of ownership, a bargain purchase option, and numeric thresholds for lease term and present value. Deloitte's Roadmap: Leases, Appendix C lays out the differences.
ASC 842-10-25-2 keeps four similar criteria, though the purchase option test now asks whether exercise is reasonably certain. It words the term and present value tests as "major part" and "substantially all." It also adds the alternative use test. ASC 842-10-55-2 describes numeric thresholds as one reasonable approach, not a requirement.
KPMG's Handbook: Leases (paragraph 6.2.260) flags another change. Most of the old real estate rules were not carried forward.
Timing changed as well. KPMG (paragraph 6.2.280) notes that ASC 840 classified a lease at inception, while ASC 842 classifies it at commencement. The table summarizes the five current criteria in ASC 842-10-25-2.
| ASC 842-10-25-2 | The lease is a finance lease if... | What to look at in the contract |
|---|---|---|
| (a) | It transfers ownership of the asset to the lessee by the end of the lease term | Title transfer clause |
| (b) | It grants a purchase option the lessee is reasonably certain to exercise | Purchase option price and the lessee's economic incentive to use it |
| (c) | The lease term is for the major part of the asset's remaining economic life | Lease term against remaining economic life; not used if the lease commences at or near the end of the asset's economic life (the exception in ASC 842-10-25-2(c)) |
| (d) | The present value of lease payments plus any lessee residual value guarantee equals or exceeds substantially all of the asset's fair value | Payment schedule, discount rate, fair value at commencement |
| (e) | The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the term | Custom build, specifications, lessor's ability to redeploy it |
Meeting any single row is enough. For how each criterion is applied in practice, see ASC 842 lease classification explained.
How does capital lease accounting compare with finance lease accounting?
The entries look familiar to anyone who booked capital leases. The differences sit in what gets measured and when it gets updated. This table sets the two side by side.
| Topic | Capital lease (ASC 840) | Finance lease (ASC 842) |
|---|---|---|
| Name on the balance sheet | Capital lease asset and capital lease obligation | Right-of-use asset and lease liability, presented or disclosed apart from operating lease balances (ASC 842-20-45-1) |
| Classification tests | Four criteria, two with numeric thresholds (lease term, present value); assessed at inception | Five criteria worded as judgments; assessed at commencement (ASC 842-10-25-2) |
| Residual value guarantees | Full guaranteed amount in minimum lease payments | Only the amount probable of being owed (ASC 842-10-30-5(f); KPMG 5.4.480) |
| Remeasuring the liability | Not remeasured during the term unless the lease was modified (KPMG 6.6.200) | Remeasured when a reassessment event occurs (ASC 842-20-35-4; events in ASC 842-10-35-1 and 842-10-35-4) |
| Operating leases | Off the balance sheet | On the balance sheet too, other than short-term leases the lessee elects to exclude (ASC 842-20-25-2; KPMG 3.1.120) |
That last row is the biggest change in practice. Under ASC 840, KPMG notes, lease assets and liabilities were recognized "only for capital leases." Now classification decides how expense is presented, not whether the lease is on the balance sheet. The off-balance-sheet financing article covers that shift.
How do you record a capital lease today?
You record it as a finance lease. On day one, ASC 842-20-30-1 measures the lease liability at the present value of lease payments not yet paid. ASC 842-20-30-5 builds the right-of-use asset from three pieces:
- the initial lease liability;
- plus lease payments made at or before commencement, minus lease incentives received;
- plus initial direct costs.
After commencement, ASC 842-20-25-5 requires the lessee to recognize amortization of the right-of-use asset and interest on the lease liability. ASC 842-20-35-1 accrues interest at a constant rate on the remaining liability. Payments reduce the liability.
ASC 842-20-35-8 amortizes the asset to the earlier of its useful life or the end of the lease term. If the lease transfers ownership or includes a purchase option the lessee is reasonably certain to exercise, the same paragraph instead amortizes the asset over the underlying asset's useful life.
Worked example: a five-year equipment lease
Every input is here, so you can check the math. The lessee leases equipment for 5 years. It pays $25,000 at the end of each year. The equipment is new, with a 5-year economic life, so the lease term covers all of it and criterion (c) is met.
The rate implicit in the lease is not readily determinable, and the incremental borrowing rate is 6%. There are no initial direct costs, incentives or prepaid rent.
The 5-year annuity factor at 6% is 4.212364. Multiply by $25,000 and the lease liability is $105,309.09. With no adjustments, the right-of-use asset is also $105,309.09.
ASC 842-20-35-7 calls for straight-line amortization unless another systematic basis better reflects how the lessee uses up the asset's benefits. Over 5 years that is $21,061.82 a year. Year 5 takes $21,061.81 so the rounding clears.
The table shows years 1 and 2; year 5 appears below. The full schedule pattern is in the lease amortization schedule article.
| Year | Opening liability | Interest at 6% | Payment | Principal reduction | Closing liability | Amortization | Total expense |
|---|---|---|---|---|---|---|---|
| 1 | $105,309.09 | $6,318.55 | $25,000.00 | $18,681.45 | $86,627.64 | $21,061.82 | $27,380.37 |
| 2 | $86,627.64 | $5,197.66 | $25,000.00 | $19,802.34 | $66,825.30 | $21,061.82 | $26,259.48 |
Year 1 entries, in order:
- Commencement: debit right-of-use asset $105,309.09; credit finance lease liability $105,309.09.
- Year-end payment: debit interest expense $6,318.55; debit finance lease liability $18,681.45; credit cash $25,000.00.
- Year-end amortization: debit amortization expense $21,061.82; credit accumulated amortization $21,061.82.
Notice the year 1 expense of $27,380.37 is higher than the $25,000 paid. Interest falls each year as the liability shrinks. So for a finance lease with straight-line amortization, total expense declines over the term.
An operating lease instead books a single lease cost, generally on a straight-line basis (ASC 842-20-25-6). The finance lease's front-loaded pattern is the main income statement difference. The operating and finance lease journal entries article shows both side by side.
Where do capital lease obligations sit on the balance sheet now?
They are finance lease liabilities, and they stay visible. ASC 842-20-45-1 requires them to be kept apart from operating lease liabilities and other liabilities. That can be on the face of the balance sheet or in the notes. If they sit inside another line item, ASC 842-20-45-2 requires the notes to say which line.
On a classified balance sheet, the liability splits into current and noncurrent. ASC 842-20-45-1 treats lease liabilities like other financial liabilities for that split, as KPMG (paragraph 6.9.40) notes. KPMG and Deloitte each accept two ways to size it.
Under one approach, the current portion at the end of year 1 is next year's principal reduction, $19,802.34. That leaves $66,825.30 noncurrent ($86,627.64 minus $19,802.34).
KPMG (Handbook: Leases, Question 6.9.10) and Deloitte (Roadmap: Leases, section 14.2) also accept a second approach. The current portion is the present value of the next 12 months' payments: $25,000 divided by 1.06, or $23,584.91. That leaves $63,042.73 noncurrent. The lease liability article shows how the liability is built.
How are capital lease payments split between interest and principal?
The math works like a loan. Each payment does two jobs. First it covers the interest accrued on the opening liability. The rest reduces the liability itself.
In year 1 of the example, $6,318.55 of the $25,000 is interest and $18,681.45 is principal.
The split shifts every year. As the balance falls, less of each payment is interest and more is principal. By year 5, interest is $1,415.09 and principal is $23,584.91, which retires the liability exactly. A full schedule makes this easy to audit; see how to build a lease amortization schedule.
Payments that change with usage or an index after commencement are treated differently. Under ASC 842-20-25-5(b), variable payments not included in the lease liability are expensed in the period the obligation is incurred. If your old capital lease involved a lease-to-own deal, the lease purchase accounting article walks through that case.
Frequently asked questions
Is a capital lease the same as a finance lease?
Close, but not identical. ASC 842 uses the term finance lease where ASC 840 said capital lease, and both put an asset and a liability on the books. But the tests and some measurement rules changed. So a former capital lease is not always a finance lease when tested fresh under ASC 842-10-25-2.
Did my capital leases become finance leases when we adopted ASC 842?
If you elected the package of practical expedients, yes. ASC 842-10-65-1(f)(2) says existing leases classified as capital leases under Topic 840 will be classified as finance leases. ASC 842-10-65-1(r)(1) then carries the capital lease asset and obligation over at their carrying amounts.
Is a lease purchase a finance lease or an operating lease?
Usually a finance lease. A lease that transfers ownership of the asset to the lessee by the end of the term meets the first criterion in ASC 842-10-25-2. So does a purchase option the lessee is reasonably certain to exercise. Meeting any one criterion makes it a finance lease.
Sources and further reading
- KPMG, Handbook: Leases. Paragraphs 3.1.120, 5.4.480, 6.2.260, 6.2.280, 6.6.200 and 6.9.40, Question 6.9.10. Its reproduction of ASC 842-10-25-2, 842-10-30-5, 842-10-55-2, 842-10-65-1(f) and (r), 842-20-25-2, 842-20-25-5, 842-20-30-1, 842-20-30-5, 842-20-35-1, 842-20-35-4, 842-20-35-7, 842-20-35-8 and 842-20-45-1 to 45-2
- Deloitte DART, Roadmap: Leases, Appendix C: Differences between ASC 842 and ASC 840
- Deloitte DART, Roadmap: Leases, section 14.2: Lessee presentation
- PwC Viewpoint, Leases guide, 3.3: Lease classification criteria
- ASC 842 lease classification guide
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