Capital Lease (Finance Lease)
A lease that transfers substantially all ownership risks to the lessee, requiring the asset and liability to be recorded on the balance sheet.
What is Capital Lease?
A capital lease — renamed a finance lease under ASC 842, which took effect for public companies in 2019 — is a lease agreement structured so the lessee effectively assumes most of the risks and benefits of ownership. Unlike an operating lease, a finance lease requires the lessee to record both a right-of-use asset and a corresponding lease liability on the balance sheet. The lessee amortizes the asset and recognizes interest expense separately over the lease term. Classification as a finance lease is triggered if the lease transfers ownership, contains a purchase option the lessee is reasonably certain to exercise, covers most of the asset's useful life, or has payments equal to substantially all of the asset's fair value.
Example
An airline leases aircraft under a 12-year agreement covering 90% of the planes' estimated useful life. Under ASC 842, this qualifies as a finance lease. The airline records a $400 million right-of-use asset and a $400 million lease liability at commencement. Over the lease term it recognizes amortization on the asset and interest expense on the liability — resulting in higher front-loaded expenses compared to an operating lease treatment.
Source: FASB — ASC 842 Leases