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Accounting for Capital Lease

What is 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.

Capital Lease Criteria

A lease is classified as a capital lease when:

  1. The lease term is greater than or equal to 75% of the asset’s useful economic life;
  2. The present value of the lease rental of such a lease is greater than 90% of the fair value of the asset leased at the time of lease; and
  3. The lessor does not legally own the asset until the end of the term and has the option to purchase it at a price less than fair market value.

Here, although the business does not legally own an asset, the business owns the risks associated with owning the asset; therefore, a capital lease is recorded as an asset on a balance sheet. A capital lease is common in sectors dealing with large assets, such as the airline industry. Now, let’s look at the accounting treatment for a capital lease. We will use an example and provide journal entries for explaining capital lease accounting.

Accounting for Capital Lease

Example – Capital Lease Accounting

Let’s say that Company A enters 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 that lease payment of Rs. 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 have an option to buy the asset at the end of the lease period at a value less than the fair market value.

AssumptionsDetails
Monthly Lease Payment Amount (MLP)INR 20,000
Term of Lease6 Years
Rate of Interest12% Annually

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

Test the Lease on Capital Lease Criteria

Criteria 1: Lease Period

Lease period covers 86% (6/7 Years) of the asset’s useful life.

Criteria 2: Present Value 

Since the payment of the lease is done 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%.

# 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 payment of the Lease is to be made at the beginning of each month, the Interest for the month of 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 interest of the first month is also to be taken into consideration, as the Asset is used for the whole month. So, 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.

DateJournal EntryDebitCredit
Jan-1-18Gross Asset (Equipment)1,033,238
Lease Liability1,033,238
Jan-1-18Lease Rental Expense (Reduction of Lease Liability)20,000
Cash (Paid to Lessor)20,000
Jan-31-18Depreciation (Reduction of Gross Asset)14,351
Depreciation Expense Account14,351

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

DateJournal EntryDebitCredit
Feb-1-18Lease Rental Expense (Reduction of Lease Liability)9,868
Interest Expense10,132
Cash (Paid to Lessor)20,000
Feb-28-18Depreciation (Reduction of Gross Asset)14,351
Depreciation Expense Account14,351

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.

MonthsLiability BeginningInterestLease RentalLiability ReductionLiability Ending
Jan-18103323820000200001013238
Feb-181013238101322000098681003370
Mar-18100337010034200009966993404
Apr-1899340499342000010066983338
May-1898333898332000010167973171
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Aug-2397069971200001902978039
Sep-2378039780200001922058820
Oct-2358820588200001941239408
Nov-2339408394200001960619802
Dec-231980219820000198020

1–3

1.
The Accounting for a Capital Lease. Accounting Tools. September 2018. [Source]
2.
Accounting for Leases. UCSB education. September 2018. [PDF]
3.
Capital Lease Accounting | Double Entry Bookkeeping. Double Entry Bookkeeping. September 2018. [Source]
Last updated on : April 25th, 2019

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