Accounting
Leases on Balance Sheets
Prior to November 1976, companies could enter into lease agreements without disclosing these agreements on their balance sheets. However, the Financial Accounting Standards Board (FASB) in 1976 began requiring that companies report certain financial leases on their balance sheets. The rationale for this ruling was that companies' balance sheets looked better when these companies had leases but did not report them. In other words, companies could have multiple lease obligations but appear to have fewer liabilities by omitting these leases on their balance sheets. Therefore, the FASB requires that companies report leases that meet one or more of the following four criteria:

• The lessee becomes the property owner by the end of the term of lease.
• The lessee can purchase the property below fair market value at the end of the leasing term.
• The leasing term constitutes 75 percent or more of the expected life of the property.
• At the beginning of the leasing term the present value of lease payments exceeds 90 percent of the property's fair market value.

When a company enters a lease agreement that meets one or more of these criteria, the lease is considered a capital lease and must be reported on a balance sheet. Future business managers should know whether particular lease agreements meet one or more of the four criteria of a capital lease, as the kinds of leases could affect how companies report their liabilities on their balance sheets.

Source: S. Ross, R. W. Westerfield, and B. D. Jordan, Fundamentals of Corporate Finance (New York: McGraw-Hill/Irwin, 2006), pp. 829–831.