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 the lease is recorded as an asset on the balance sheet.

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:

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.

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 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.

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 for 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

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