Capital Lease

Question: One slight change can move this contract from an operating lease to a capital lease. Assume all the

information remains the same in the above example except that the airplane has an expected life of only nine years

rather than ten. With that alteration, the life of the lease is 77.8 percent of the life of the asset (seven years out of

nine years). That is 75 percent or more of the life of the asset. Because one of the criteria is now met, this contract

must be viewed as a capital lease. The change in that one estimation creates a major impact on the reporting

process. How is a capital lease reported by the lessee?

Answer: As a capital lease, the transaction is reported in the same manner as a purchase. Abilene has agreed to

pay $100,000 per year for seven years but no part of this amount is specifically identified as interest. According

to U.S. GAAP, if a reasonable rate of interest is not explicitly paid each period, a present value computation is

required to divide the contractual payments between principal (the amount paid for the airplane) and interest (the

amount paid to extend payment over this seven-year period). This handling is appropriate for an actual purchase

when payments are made over time but also for a capital lease.

Before the lessee starts computing the present value of the future cash flows, one issue must be resolved: the

appropriate rate of interest to be applied. In the previous chapter, a negotiated rate was established by the buyer

and seller of a bond prior to its issuance. Normally, no such bargained rate exists in connection with a lease.

Therefore, the lessee uses its own incremental borrowing rate. That is the interest rate the lessee would be forced

to pay if this same amount of money was borrowed from a bank or other lending institution1.