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
- Ownership- The ownership is shifted to the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more at the end of the lease period.
- Bargain purchase option- Lessee can buy an asset at the end of term at a value below market price.
- Lease term- Lease term comprises at least 75% of the useful life of the asset.
- Present value- The present value of the lease payment is 90% of the fair value of the asset at the beginning.
Accounting Treatment of Capital Lease
Below is the impact of Capital Leases on the Lessee Account.
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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.
- 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
- Interest Expense – The periodic payments to pay the lease needs to be broken down as per the interest payments at an applicable interest rate. Interest expense is calculated as Discount rate times the Lease liability at the beginning of the period
- Depreciation Expense – Since the leased asset is a fixed asset, it is liable to depreciation. It, therefore, also needs to calculate the useful life of the asset and, ultimately, its salvage valueSalvage ValueSalvage 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.
Effect on Cash Flows
- Only the portion of lease payment that is considered interest payment reduces Cash flow from Operations (CFO)Cash Flow From Operations (CFO)Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more
- Part of the lease payment considered payment on principal reduces Cash flow from Financing (CFF).
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.
- The ownership is shifted to the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more at the end of the lease period.
- The lessee can buy an asset at the end of term at a value below market price.
- The lease term comprises at least 75% of the useful life of the asset.
- The present value of the lease payment is 90% of the fair value of the asset at the beginning.
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
#2 – During the Remaining Months
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.
- The ownership is shifted to the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more at the end of the lease period.
- The lessee can buy an asset at the end of term at a value below market price.
- The lease term comprises at least 75% of the useful life of the asset.
- The present value of the lease payment is 90% of the fair value of the asset at the beginning.
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
#2 – During the Remaining Months
*Present Value = MLP + MLP* (1- (1 + Monthly Interest Rate)^(- No. of Periods+1))/Monthly Interest Rate
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