In a capital lease, the lease obligation should be recorded at the lower of which values?

• A. Present value of the stream at the beginning of the lease (excluding executory costs) and the fair value of the leased property
• B. Annual rent payments
• C. The fair value of the leased asset only
• D. Future tax benefits

Answer: (A)

When a lease is accounted for as a capital (finance) lease, you recognize a lease liability and a corresponding asset for the right to use the asset. The amount you record for both is the lower of two measurements: the present value of the minimum lease payments at the start of the lease (excluding executory costs) and the fair value of the leased asset. This rule keeps the initial recognition from overstating either the liability or the asset.

The present value of minimum lease payments is computed using the rate implicit in the lease if available, or the lessee’s incremental borrowing rate if not, and it includes fixed payments and other payments required during the lease term (such as guaranteed residuals or purchase options that are reasonably certain to be exercised), but excludes executory costs like taxes, insurance, and maintenance.

If the fair value of the asset is lower than the present value of the minimum lease payments, you would use the fair value; if the PV of the payments is lower, you use that amount. The asset is subsequently amortized, and interest accrues on the liability over the lease term.