Accounting for Capital Lease – Steps, Accounting Entries and More

Capital Lease Accounting

Capital lease accounting relates to the treatment of assets taken on lease by a business under a capital lease agreement with a lessor. In a capital lease, the asset(s) taken on lease is recorded as an asset on the balance sheet.

In a capital lease agreement, the lessee (the one who rents the asset) does not end up owning the leased asset until the end of the lease agreement period. At the end of the lease term, the lessee has the option to buy the leased asset. Before you determine the accounting entry of a capital lease agreement, you need to ensure that the lease is actually a capital lease and not an operating lease.

Criteria to Determine Capital Lease-ASC840

A lease is classified as a capital lease when it meets the following criteria as provided under ASC840:

  1. Whether the lease provides for the transfer of ownership to the lessee at the end of the lease term.
  2. Whether the lessee has the option to purchase the leased asset at a price less than fair market value or say at a bargain price.
  3. The lease term is greater than or equal to 75% of the asset’s useful economic life;
  4. The present value of the lease rental of such a lease is greater than 90% of the asset leased’s fair value at the time of lease.

Here, although the business does not legally own an asset, the business owns the risks associated with owning the asset.

Introduction of 5th Criteria-ASC842

Over the years, the nomenclature of Capital Lease is now changing to Finance Lease. Because in most such cases, though, all the risk of the assets lies with the Lessee; however, funding is provided by the Lessor. And that funding is paid back to the Lessor in the form of lease rentals, which comprises the principal and an interest portion. Secondly, in most cases, the leased asset is ultimately bought by the Lessee at a bargain value, as compared to the fair market value.

Considering the above situation, ASC 842 has added one more important criterion to define such leases as a Finance Lease. Therefore, the Fifth criteria are:

5. The leased asset is specialized or unique in nature. And such an asset will not be of any value to the Lessor at the expiry of the lease term.

Capital Lease and Operational Lease

It would be appropriate to understand the basic characteristics of both these types of leases. Because it will afford us clarity for the accounting treatment to be given to such leases.

Operational Lease or Traditional Lease is that where the ownership, asset-related risk, asset transfer, and asset-buying option at the end of the term does not remain with the Lessee. Instead, Lessor takes the risk or share with Lessee as agreed. At the end of the lease term, the asset is returned to the Lessor. The lessee can only use the assets and pay the lease rentals to the lessor as agreed.

On the other hand, Capital Lease, or now renamed Finance Lease, has all these features inbuilt in the lease agreement. Virtually the lessee treats the assets as owned or purchased by him, remains responsible for all the associated risks, usually buyback that very asset from the lessor on expiry of the lease term.

The above distinction like lease differentiates the accounting treatment for such leases. In the case of an operational lease, only lease rental payment is the single entry in the accounting records. And this lease rental payment flows to the profit and loss account. Moreover, the asset remains an out of the balance sheet item and hence, no depreciation calculation is considered.

However, in the case of Capital Lease or Finance Lease, the asset leased gets the same treatment given to an asset purchased or owned by the business. All expenses find its way to the profit and loss account; the leased assets reflect as an asset and other assets owned by the entity. Moreover, depreciation calculation on this leased asset also happens like any other asset, considering the lease term.

Pros and Cons of Capital Lease

The capital lease has several pros:

  1. Like a business-owned asset, the leased asset will also reflect as part of the entity’s total assets in its balance sheet. Therefore, this arrangement increases the asset base of the entity.
  2. Again the interest portion included in the lease rental will find its place in the profit and loss account. And the tax benefits can be availed by the entity like an operational lease.
  3. Moreover, as with owned assets, the business can continue to charge the depreciation on the leased assets. And thus, continue to enjoy the tax benefits, which is not possible in an operational lease.

The capital lease also has certain negatives too. As the asset base increases, the efficiency ratio in terms of- Asset Turnover Ratio or Fixed Asset Turnover Ratio goes down. And that may not look good for the entity.

Accounting for Capital Lease

Capital Lease Accounting Process

As discussed above, broadly, such an asset has to be given the accounting treatment as an owned and financed asset. For that, one needs to take the following steps before making the actual journal entries in the books of account:

  1. First of all, one needs to categorically understand by going through the lease agreement, whether the arrangement meets all the criteria of being termed as a Capital Lease.
  2. To book the asset and create a liability for the same in the books, you need to put a value to the asset.
  3. It is determined by calculating the Present Value of all the lease payments to be made over the lease period.
  4. As we know, the regular lease rental consists of two parts – lease rental towards assets value or say towards the principal and the interest portion. Hence, one needs to segregate these two portions from the monthly lease rental.
  5. The first potion will be posted to the lease liability account, which will over the years, reduce the lease liability.
  6. The interest portion will flow to the profit and loss account at the end of the year.
  7. Finally, each year depreciation needs to be calculated and recorded for the asset. This will also flow to the profit and loss account every year.
  8. Thus, all these steps will mean all the interest and depreciation will flow to the profit and loss account, and the company can take tax advantage of that. Moreover, the lease liability account will become zero at the end of the lease term. And the asset will mostly stand in the balance sheet either fully depreciated or with a nominal depreciated value. Now let’s understand these steps and accounting entries with an example.

Example – Capital Lease Accounting

Let’s say that Company A entered into a capital lease contract to lease out an airplane with Company B on January 1, 2018. The agreement is to lease the airplane worth $1,100,000 for a period of 6 years. The airplane’s useful life is 7 years. The contract specifies the lease payment of $20,000 should be made at the beginning of each month for 6 years. There is no salvage value at the end of the lease period. The lessee will choose to buy the asset at the end of the lease period at a value less than the fair market value.

Assumptions Details
Monthly Lease Payment Amount (MLP) $ 20,000
Term of Lease 6 Years
Rate of Interest 12% Annually

Let’s first test whether the transaction falls under Capital Lease Criteria:

Test the Lease on Capital Lease Criteria

Criteria 1: Lease Period

The lease period covers 86% (6/7 Years) of the asset’s useful life. It satisfies the criterion of 75%.

Criteria 2: Present Value 

Since the lease payment is made at the beginning of each month, the present value of the monthly lease rentals is calculated accordingly. #1,033,238 i.e. 94% (1,033,238 / 1,100,000) of the current value of the asset, which is more than 90%. See the calculation below:

# Present Value of the airplane = MLP + MLP* (1- (1 + Monthly Interest Rate)^(- No. of Periods+1))/Monthly Interest Rate

PV of the airplane = 20000 + 20000* (1 – (1 + 1%)^(- 72 + 1)) / 1% = 1033237.91 ~ $1,033,238.

Monthly Interest Rate = 12% Annually / 12 Months = 1% Monthly

No. of Periods = 6 Years * 12 Months = 72 Periods

Now, if the payment of the lease is to have been made at the end of each month, then the formula would have been;

Present Value of the airplane = MLP* (1 – (1 + Monthly Interest Rate)^(- No. of Periods))/Monthly Interest Rate

PV of the airplane = 20000* (1 – (1 + 1%)^(-72)) / 1% = 1023007.83 ~ $1,023,008

Criteria 3: Option to Buy 

Yes, as per the contract, this option is also present.

Before we proceed into the Journal Entries, let’s do some preparatory calculations required before recording journal entries.

Steps to Capital Lease Accounting

We should follow certain steps one by one to accurately account for the capital lease.

Step 1: Calculate Present Value

As we have already calculated under the capital lease criteria test, our present value is 1,033,238.

Step 2: Calculate Interest Expense

Here, because the lease payment is to be made at the beginning of each month, the Interest for January 2018 is not made, as the Asset has not been used yet by the Lessee. So, the first installment or lease rental will begin from January 1, 2018. Principal Amount for Interest Calculation = Total Asset Value less Lease Rental Paid = 1033238 – 20000 = 1013238.

Considering the second alternative, if the payment is to be made at the end of each month, the first month’s interest is also to be taken into consideration, as the Asset is used for the whole month. The first installment or lease rental would begin from January 31, 2018, until January 31, 2024. Hence, the Principal Amount for Interest Calculation = Total Asset Value = 1033238.

Interest Rate = 1% for the month.

Interest Expense = 1013238* 1% = 10132.38 ~ 10132

Step 3: Calculate Lease Liability Reduction

We know that the total monthly lease rental payment is $20,000, and the Interest Cost, as assessed above, is 10132. Net liability reduction in the second month onwards will be equal to:

MLP Less Interest Exp. = 20000 – 10132 = 9868

The detailed calculation can be seen in the monthly table below.

Step 4: Calculate Depreciation

The value of the airplane is 1033238 for 72 months. Per month depreciation is equal to 1033238/72 = 14350.53~ 14351.

Journal Entry for Capital Lease

Now, let’s look at the entries that will take place for capital lease in the books of the lessee:

Entry in the first period or first month, in our case.

Date Journal Entry Debit Credit
Jan-1-18 Gross Asset (Equipment) 1,033,238  
  Lease Liability   1,033,238
       
Jan-1-18 Lease Rental Expense (Reduction of Lease Liability) 20,000  
  Cash (Paid to Lessor)   20,000
       
Jan-31-18 Depreciation (Reduction of Gross Asset) 14,351  
  Depreciation Expense Account   14,351

Entry in the second period or second month, in our case. The following entries will follow for the entire lease period.

Date Journal Entry Debit Credit
Feb-1-18 Lease Rental Expense (Reduction of Lease Liability) 9,868  
  Interest Expense 10,132  
  Cash (Paid to Lessor)   20,000
       
Feb-28-18 Depreciation (Reduction of Gross Asset) 14,351  
  Depreciation Expense Account   14,351

Capital Lease Accounting Table

The following table will show the calculation for capital lease accounting. This can be used to record journal entries in each of the 72 months.

Months Liability Beginning Interest Lease Rental Liability Reduction Liability Ending
Jan-18 1033238   20000 20000 1013238
Feb-18 1013238 10132 20000 9868 1003370
Mar-18 1003370 10034 20000 9966 993404
Apr-18 993404 9934 20000 10066 983338
May-18 983338 9833 20000 10167 973171
           
           
Aug-23 97069 971 20000 19029 78039
Sep-23 78039 780 20000 19220 58820
Oct-23 58820 588 20000 19412 39408
Nov-23 39408 394 20000 19606 19802
Dec-23 19802 198 20000 19802 0

Frequently Asked Questions

How is a capital lease recorded on the balance sheet?

A capital lease accounting has broadly 3 effects on the balance sheet.
1. Asset is recorded on the Gross Assets.
2. A liability for Lease is also recorded on the liability side.
3. Although depreciation is expensed in income and expenditure account, it also becomes part of accumulated depreciation in the balance sheet to show net book value of assets (Gross Assets less Accumulated Depreciation).

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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5 thoughts on “Accounting for Capital Lease – Steps, Accounting Entries and More”

    • Thanks, Wilson for visiting our site and raising a query. Please note that depreciation accounting for leasing is no different than the general one. Whenever we show the gross block (original cost of the asset throughout) we debit the depreciation expense to the profit, and loss Or Income and Expenditure Account and credit the same as Depreciation (accumulated depreciation) account.

      This way debit happens in the P&L and this credit balance is shown as a deduction from the gross block from the fixed assets. So credit is only the accumulated depreciation charged so far in the P&L account and after deducting this from the gross block we get the depreciated value of the fixed assets. Do hope we have been able to clear your doubts. Thanks

      Reply
  1. What would happend to the future interest if payment in any given month was not paid as the lease liability ending balance of that month will be different comparing to previous calculation

    Reply
    • Simple. The unpaid installments will accumulate and will carry further interest and/or penalties, as per the provisions of the Lease Arrangement. Hope this answers your query. Thanks

      Reply

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