Accounting for Capital Lease

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. 

Assumptions Details
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
Lease Liability 1,023,008
Journal Entry At End of Month 1 Debit Credit
Interest Expense 10,030
Lease Rental (Debit to Lease Liability Account) 20,000
Depreciation (Reduction of Gross Asset) 14,208
Cash 30,030
Depreciation Expense Account 14,208

References:


Last updated on : July 15th, 2017
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    Meaning and Types of Liabilities
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