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 the 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.
- Capital Lease Accounting
- Criteria to Determine Capital Lease-ASC840
- Introduction of 5th Criteria-ASC842
- Capital Lease and Operational Lease
- Pros and Cons of Capital Lease
- Capital Lease Accounting Process
- Example – Capital Lease Accounting
- Steps to Capital Lease Accounting
- Journal Entry for Capital Lease
- Capital Lease Accounting Table
- Frequently Asked Questions
Criteria to Determine Capital Lease-ASC840
A lease is classified as a capital lease when it meets the following criteria as provided under ASC840:
- Whether the lease provides for the transfer of ownership to the lessee at the end of the lease term.
- 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.
- The lease term is greater than or equal to 75% of the asset’s useful economic life;
- 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 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.
An operational Lease or Traditional Lease is 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 shares 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 into 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 the balance sheet item, and hence, no depreciation calculation is considered.
However, in the case of a 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 their 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:
- Like a business-owned asset, the leased asset will also reflect as part of the entity’s total assets on its balance sheet. Therefore, this arrangement increases the asset base of the entity.
- 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.
- 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.
Read Benefits and Drawbacks of Capital Lease for more details.
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:
- First of all, one needs to categorically understand by going through the lease agreement whether the arrangement meets all the criteria of being termed a Capital Lease.
- To book the asset and create a liability for the same in the books, you need to put a value on the asset.
- It is determined by calculating the Present Value of all the lease payments to be made over the lease period.
- 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.
- The first potion will be posted to the lease liability account, which will, over the years, reduce the lease liability.
- The interest portion will flow to the profit and loss account at the end of the year.
- Finally, each year’s depreciation needs to be calculated and recorded for the asset. This will also flow to the profit and loss account every year.
- 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 on 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 6 years. The airplane’s useful life is 7 years. The contract specifies the lease payment of $20,000 should be made at the beginning of each month for 6 years. There is no salvage value at the end of the lease period. The lessee will choose to buy the asset at the end of the lease period at a value less than the fair market value.
|Monthly Lease Payment Amount (MLP)||$ 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 proceeding with 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 on 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 the capital lease in the books of the lessee:
Entry in the first period or first month, in our case.
|Jan-1-18||Gross Asset (Equipment)||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.
|Feb-1-18||Lease Rental Expense (Reduction of Lease Liability)||9,868|
|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 for each of the 72 months.
|Months||Liability Beginning||Interest||Lease Rental||Liability Reduction||Liability Ending|
Frequently Asked Questions
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 the income and expenditure account, it also becomes part of accumulated depreciation in the balance sheet to show the net book value of assets (Gross Assets less Accumulated Depreciation).