According to the FASB, what defines a capital lease?

The correct answer focuses on the definition of a capital lease as defined by the Financial Accounting Standards Board (FASB). A capital lease is characterized by the transfer of substantially all risks and rewards of ownership from the lessor to the lessee. This means that although legal title may remain with the lessor, the lease essentially grants the lessee the benefits and drawbacks of ownership over the asset.

This classification is significant as it affects how the lease is recorded in financial statements. Under capital leases, the lessee must capitalize the asset and the corresponding liability on their balance sheet, reflecting a more extensive obligation than that seen in an operating lease.

Other choices create confusion regarding the distinguishing traits of a capital lease. For instance, a lease with minimal payment terms does not necessarily capture the economic essence of the transaction as it does not indicate who bears the risks and rewards. A lease that allows sub-leasing does not define whether the lease is capital or operating; it simply indicates a degree of flexibility in the lessee’s rights. Lastly, a lease where the lessor retains all ownership rights aligns more closely with an operating lease rather than a capital lease, as it implies the lessor still maintains the economic benefits of the asset.