Capital Lease Accounting

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Capital lease accounting refers to the accounting treatment of assets leased by a business under a capital lease agreement. 

What is a Capital Lease?

A lease is a contract in which the owner of an asset agrees to rent it to another party. In a capital lease agreement, the asset gets transferred to the books of the lessee at the beginning of the lease period. 

Let’s understand this concept better with the example of Bob’s Donut Shoppe, Inc., one which we’ve used throughout to explain the concepts of accounting

Let’s say Bob needs expensive donut equipment to expand the capacity of his donut shop. But Bob doesn’t have the money to invest upfront in this equipment. So he takes it on lease from an equipment manufacturer, say, Donut Equipments, Inc. 

Under traditional accounting, this equipment will show up as an asset in the balance sheet of Donut Equipments, Inc., because they own the equipment. However, under a capital lease agreement, this equipment will show up as an asset in the balance sheet of Bob, even though he’s taken it on lease. 

Capital Lease Criteria

For a lease to qualify as a capital lease, it needs to meet one of the following three criteria:

  1. The life of the lease must be 75% or greater than the asset’s useful life.
  2. The present value of total monthly lease payments should be more than 90% of the asset’s fair market value.
  3. The lessee should gain ownership of the asset at the end of the lease period.

Example of Capital Lease Accounting

Continuing with the example of Bob’s Donut Shoppe, Inc., let’s say Bob leases equipment worth $20,000 from Donut Equipments, Inc. on January 1, 2020. 

Assumptions

Lease amount$20,000
Lease period52 months
Useful life of the equipment66 months
Rate of interest6% per annum (0.5% per month)
Monthly lease payment (to be made at the beginning of each month)$425
Depreciation expenseUnder the straight-line method$303 every month for 66 months

Testing the Capital Lease Criteria

  • Criteria 1: Lease life. The lease period covers more than 75% of the asset’s useful life, and meets criteria 1.  
  • Criteria 2:  Present value. Using our present value of an annuity calculator, we get the present value of the cash outflows as lease payments as ~ $19,418. This amount meets criteria 2. 
  • Criteria 3: Ownership. We assume the contract has a clause that allows the lessee (Bob) to gain ownership of the equipment at the end of the lease period.

Preparation for Journal Entries

Before moving to journal entries, let’s list all the business events taking place during the course of the lease. 

Jan 1, 2020 – Bob takes an asset worth $20,000 on lease and agrees to pay $425 every month for the next 52 months. And because he hasn’t paid any cash to acquire this asset, it’s a liability for his business. 

The monthly lease payment of $425 includes an interest component as well as some repayment towards principal. So, every monthly payment reduces the original liability of Bob. 

Jan 1, 2020 – Bob makes the first monthly lease payment of $425.

Jan 30, 2020 – Depreciation expense is recorded to account for the wear and tear of the asset. 

April 30, 2024 – Bob makes the final monthly payment (assuming he doesn’t purchase the equipment before that.)

April 30, 2024: While the monthly lease payments are no longer due, the useful life of the asset is 66 months. Therefore, depreciation expense needs to be recorded till June 30, 2025.

June 30, 2025 – At the end of the useful life of the asset, depreciation expense is recorded for the final time.

PeriodMonthPaymentLiability at the beginningInterestPrincipalDepreciation
1Jan 2020$425$20,000$100$325$303
2Feb 2020$425$19,675$98$327$303
3Mar 2020$425$19,348$97$328$303
4Apr 2020$425$19,020$95$330$303
5May 2020$425$18,690$93$332$303
6Jun 2020$425$18,359$92$333$303
7Jul 2020$425$18,025$90$335$303
8Aug 2020$425$17,691$88$337$303
49Jan 2024$425$2,418$12$413$303
50Feb 2024$425$2,005$10$415$303
51Mar 2024$425$1,590$8$417$303
52Apr 2024$42500$425$303
63Mar 2025$303
64Apr 2025$303
65May 2025$303
66Jun 2025$303

Journal Entries for Capital Lease

DateAccount NameDebit (dr)Credit (cr)
Jan 1, 2020Equipment$20,000
Capital lease liability$20,000
Jan 1, 2020Interest$100
Capital lease liability$325
Cash$425
Jan 31,2020Depreciation$303
Accumulated Depreciation$303
Feb 1, 2020Interest$100
Capital lease liability$325
Cash$425
Feb 29, 2020Depreciation$303
Accumulated Depreciation$303
Apr 1, 2024Interest$0
Capital lease liability$425
Cash$425
Apr 30, 2024Depreciation$303
Accumulated Depreciation$303
June 30, 2025Depreciation$303
Accumulated Depreciation$303
June 30, 2025Accumulated Depreciation$20,000
Equipment$20,000

Journal Entries Explained

Jan 1, 2020: Bob gets the equipment, and the asset account is debited. To account for the liability, a corresponding capital lease liability account is credited. 

Jan 1, 2020: Bob’s payment of $425 is credited to his cash account. Interest expense and capital lease liability accounts are debited with their respective amounts. 

Jan 31, 2020: Depreciation expense is recorded as a debit entry, and accumulated depreciation account is credited.

April 1, 2024: The final monthly lease payment of $425 doesn’t have any interest component. The principal balance as of March 1 2024 is $417, so the final payment takes care of this repayment. That’s why only the capital lease liability account is debited. 

June 30,2025: The final depreciation expense is accounted for. And now that depreciation expense has been fully accounted for over the course of its useful life, the asset is written off from the books. It will no longer show as an asset in the equipment account.