Capital Lease Accounting

What is Capital Lease Accounting?

Capital Lease accounting is done by following the principle of substance over form wherein the assets are recorded in the books of lessee as fixed assets. Depreciation is charged on the asset as normal over the term of the agreement. The lease rent payments are divided into principal and interest and charged to the profit and loss account.

Capital leaseCapital LeaseA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature.read more refers to a type of lease where all the rights related to the assets are transferred to the lessee and lessor only finance the asset. 

Basic criteria for recognizing capital lease

Below are the criteria for Capital Lease ClassificationCriteria For Capital Lease ClassificationCapital lease criteria includes the following 1) transfer of ownership to lessee 2) option to purchase the leased asset at the price below the market price 3) lease period is at least 75% of the assets economic life 4) minimum lease payment’s present value must be at least 90% of the asset’s fair value.read more

Accounting Treatment of Capital Lease

Below is the impact of Capital Leases on the Lessee Account.

Capital Lease Accounting

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For eg:
Source: Capital Lease Accounting (wallstreetmojo.com)

Effect on Balance Sheet

There are two ways the balance sheet is affected by Capital Lease.

lessee-perspective-balance-sheet-impact-of-capital-lease
  • At Inception (Start of the Capital Lease) – At this point, the company records the present value of minimum lease payments as the value of the Assets and an equal amount as Liability.
  • After Lease Payments are made – the lease payments are made, cash is reduced on the asset side, and also, the rental property is reduced by the depreciation amount. On the liabilities side, it has two effects, Lease obligation is reduced by the lease payment LESS the interest payments, and the shareholder’s equity is reduced by the interest expense and depreciation expense amount.

Effect on Income Statement

Effect on Cash Flows

Examples

Below are a few examples to explain the recording of the capital lease in books of accounts.

Example #1

The value of machinery is $11,000, and useful life is 7 years. The scrap value of the assetScrap Value Of The AssetSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more at the end of useful life is nil. The monthly lease payment at the end of each month is $ 200. The lease term was for 6 years, and the interest rate stood 12%. Pass the journal entries in books.

Solution: We need to check the basic four criteria to check if it’s a capital lease.

There is no title transfer at the end. Neither there is a bargain purchaseA Bargain PurchaseBargain purchase happens when a company acquires another company at a price less than the fair market value of its assets.read more option. The lease term is 6 years, while the useful life is 7 years, so the criteria are met here. For checking the fourth criteria, we need to calculate the present value of monthly payments of $200. The present value* of the lease payment is $1,033, which is greater than 90% of the fair value of the asset. Therefore, it’s a capital lease.

  • Number of months = (6*12) i.e. 72 months
  • *Present value of minimum lease payment= $1,033
  • Depreciation= ($11,000/7) i.e. $1,571
  • Interest for 1st month @ 1% of present value= $10
  • Lease liability- interest expense= 200-10= $190

Journal Entries 

#1 – During the First Month

Journal Entries 1

#2 – During the Remaining Months

Journal Entries 2

Example #2

A vehicle has a fair value of $16,000 and a lease term of 3 years. The monthly payment of lease is $500, out of which $50 relates to maintenance. The interest rate in the market is 4%. The useful life of the vehicle is 8 years. At the end of the lease contract, the lessee can purchase the asset at $1000. What type of lease is this?

Solution: We need to check the basic four criteria to check if it’s a capital lease.

There is no title transfer at the end. Neither there is a bargain purchase option. The lease term is 3 years, while the useful life is 8 years. 3 years is less than 75% of 8 years, so the three tests for capital lease accounting are not met. For checking the fourth criteria, we need to calculate the present value of monthly payments of $450 (excluding maintenance) The present value* of the lease payment is $15,292, which is greater than 90% of the fair value of the asset (90% of $16,000 is $14,400). Therefore, it’s a capital lease.

  • Number of months = (3*12) i.e. 36 months
  • *Present value of minimum lease payment= $15,292
  • Depreciation= ($16,000/8) i.e. $2,000
  • Interest for 1st month @ 4% of present value= $50
  • Lease liability- interest expense= 450-50= $400

Journal Entries

#1 – During the First Month

Journal Entry 3

#2 – During the Remaining Months

Journal Entry 4

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

This has been a guide to what is Capital Lease Accounting. Here we discuss how to record journal entries for capital lease along with examples. You can learn more about accounting from the following articles –

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