What is Capital Lease Accounting?
The accounting for capital lease is done considering the property to be owned by the lessee and recording such property as a fixed asset in the books of accounts of the lessee, charging depreciation on the same and the lease payments are charged to P&L after dividing the amount as principal and interest.
It provides guidelines on how the capital lease asset should be recorded by the business in its balance sheet, income statement, and cash flows. Capital lease 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. Following the principle of substance over form, assets are recorded in books of the 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.
Basic criteria for recognizing capital lease
Below are the criteria for Capital Lease Classification
- Ownership- The ownership is shifted to the lessee 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 of at least 75% of the useful life of the asset
- Present value- The present value of 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.
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 value.
Effect on Cash Flows
- Only the portion of lease payment that is considered interest payment reduces Cash flow from Operations (CFO)
- Part of the lease payment considered payment on principal reduces Cash flow from Financing (CFF).
Capital Lease Accounting Examples
Below are 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 asset 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 lessee at the end of the lease period.
- The lessee can buy an asset at the end of term at a value below market price
- 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 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 lessee at the end of the lease period.
- The lessee can buy an asset at the end of term at a value below market price
- 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
Conclusion
- A capital lease is a type of lease where all the rights related to the assets are transferred to the lessee and lessor only finance the asset.
- The lessee records the interest portion of the lease payment as expense in profit and loss account.
- Fulfillment of any one of the four criteria leads to classification as a capital lease.
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