Capital lease accounting shows treatment of assets taken on lease by the business under a capital lease agreement with the lessor. In a capital lease, asset taken on lease is recorded as an asset on the balance sheet.
In the capital lease agreement, the lessee (the one who rents the asset) does not end up owning the leased asset, until the end of lease agreement period. At the end of the lease term, the lessee returns the asset to the lessor and if required, a new capital lease agreement is entered into. Before you start figuring out 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.
A lease is classified as capital lease when,
- The lease term is greater than 75% of the asset’s useful economic life.
- The lease rental expenses of such a lease are greater than 90% of the market value of the asset leased and
- The lessor does not legally own the asset until the end of the term and has the option to purchase it 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 and hence capital lease is recorded as an asset on a balance sheet. A capital lease is common to sectors dealing with large assets, for example, the airline industry. Now let us look at the accounting treatment for a capital lease. We will take example and show journal entries for explaining capital lease accounting.
Accounting for Capital Lease with Example
Let’s say that a Company A enters into a capital lease contract to lease out an Aeroplane with Company B. The agreement is to lease the Aeroplane worth INR 10, 00,000 for a period of 6 years. The Aeroplane’s useful life is 5 years. The contract specifies that first lease payment of Rs. 20,000 should be made at the beginning of each month. There is no salvage value at the end of the lease period.
|Monthly Lease Payment Amount||INR 20,000|
|Term of Lease||6 Years|
|Rate of Interest||12%|
|Total Period(n)= (Term of Lease X Number of Months)||72 Months|
|Annuity Factor (f) = (1-(1+r)^-n)/r||51.15039148|
|Total Asset Value||INR 1,023,008|
Journal Entry for Capital Lease
|Journal Entry At Beginning of Year 1||Debit||Credit|
|Gross Asset (Equipment)||1,023,008|
|Journal Entry At End of Month 1||Debit||Credit|
|Lease Rental (Debit to Lease Liability Account)||20,000|
|Depreciation (Reduction of Gross Asset)||14,208|
|Depreciation Expense Account||14,208|