In order to record a lease as a capital lease, the lease must be non-cancelable. Further, it must meet one or more of the four criteria listed as below:
• The lease transfers ownership of the property to the lessee. If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is not controversial and easily implemented in practice.
• The lease contains a bargain-purchase option. A bargain-purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable. At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured.
• If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate. However, determining the lease term and the economic life of the asset can be troublesome. The lease term is generally considered to be the fixed, noncancelable term of the lease. However, a bargain-renewal option, if provided in the lease agreement, can extend this period. A bargain-renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured.
• If the present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the asset, then a lessee should capitalize the leased asset. If the present value of the minimum lease payments is reasonably close to the market price of the aircraft, lessee is effectively purchasing the asset.