Accounting for Capital Leases: What You Need to Know

February 16, 2023
Lease Management

Capital lease accounting adheres to the concept of substance over form.

As a consequence, accurate capital lease accounting may appear complicated at first glance because of the large number of variables involved (lease payments, asset identification, depreciation, interest, etc.). 

So, here is a comprehensive guide that covers all aspects associated with capital leases, from accounting treatment to examples. Let's get started. 

What is Capital Lease Accounting?

Before digging into capital lease accounting, first, let's understand what a capital lease is.

When a lessee enters into a capital lease, it treats the underlying asset as if it's fully owned by the lessee. In contrast, a lessor is considered an entity that provides funding for the asset whose ownership rights have been transferred to the lessee. 

Accounting for capital leases refers to a method in which a company treats assets that it has leased from a lessor in accordance with a capital lease agreement. In the case of a capital lease, the assets being leased get represented on the balance sheet as an asset.

The lessee does not end up with the ownership of the leased asset until the lease agreement period has concluded under a capital lease arrangement. They have the choice to purchase the leased asset after the period of the lease has come to an end.

One must be certain that the lease they are considering is a capital lease and not an operating lease before proceeding with determining the accounting record that corresponds to the capital lease agreement.

accounting concept. businesswoman working using calculator with money stack in office

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Criteria for Determination of a Capital Lease

When a lease satisfies the following conditions, as specified in ASC 842, it is categorized as a capital lease and gets treated as such:

  • Check to determine if the lease includes a provision that gives the lessee ownership of the asset once the term of the lease has expired.
  • Whether the lessee has the choice to acquire the leased asset at a price that is cheaper than the asset's current fair market value or at a discounted price.
  • The lease term is more than or equal to 75% of the useful economic life of the asset.
  • The current value of the lease rental for such a lease is higher than 90% of the leased asset's fair value during the lease.
  • The nature of the leased asset can be described as unique or specialized. At the end of the lease term, such an asset will have no worth to the lessor.

Steps Involved in Accounting for the Capital Lease

If a leased asset is determined to be a capital lease after being evaluated based on these criteria, then the accounting for the lease will consist of the following actions:

  • Initial Recordation

Determine the current value of all lease amounts; this will represent the reported asset cost. Make a note of the amount by making a debit entry into the relevant account for fixed assets and a credit entry into the capital lease liabilities account.

For instance, if the total present value of the lease payouts for manufacturing equipment comes to $25,000, it should be recorded as a debit of $25,000 to the account that is designated for the machine and a credit of $25,000 to the account that is designated for the capital lease liability.

  • Lease Payments

When the business gets lease invoicing from the lessor, a proportion of each invoice should be recorded as an interest expense, and the remaining portion should be used to reduce the balance in the capital lease liability account.

It is recommended that the amount held in the capital lease liability account be reduced until it reaches zero.

For instance, say a lease payment was for a sum of $3,000, and $100 of that sum was for interest expense.

The capital lease journal entry would consist of a debit of $2900 (to the account for the capital lease liability), a debit of $100 (to the account for the interest expense), and a credit of $3,000 (to the account for accounts payable).

  • Depreciation

Since an asset that has been recorded through a capital lease is fundamentally identical to any other type of fixed asset, it's required to be depreciated conventionally.

This implies that periodic depreciation must be calculated based on a conjunction of the documented asset cost, any residual value, and the asset's useful life.

For example, the annual depreciation entry for an asset with a cost of $1000, no projected salvage value, and a useful life of 5 years might look like this: a debit of $1,000 from the depreciation expense account and a credit to the accumulated depreciation account.

  • Disposal

When an asset is sold or otherwise disposed of, its remaining amount in the fixed asset account gets credited, and its remaining balance in the accumulated depreciation account is deducted.

A profit or a loss gets recognized in the period that corresponds to the disposal transaction if the proceeds from the sale exceed the asset's net carrying amount.

The accounting for a "normal" fixed asset and then one obtained through a lease are identical, except for the initial asset cost and the accounting of lease payments.


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Accounting Treatment of Capital Leases

Let's examine the effect of capital leases on the lessee's account.

Effect on Balance Sheet 

Capital lease has two distinct implications on the balance sheet, both of which are important to understand. 

  • At the beginning of the capital lease - The business registers the current value of the minimum lease payments as the worth of the assets while also recording an equivalent amount as a liability.
  • After making lease payments - The assets' cash balance gets lowered, whereas the depreciation amount is subtracted from the rental property's value.
  • There are two results on the liabilities side of things. A lease payment minus interest payments reduce the lease obligation, and interest expenditure and depreciation expense lessen shareholder equity.

Effect on Income Statement

  • Interest Expense – It is necessary to segment the recurrent payments to pay off the lease in accordance with the interest payments at the relevant interest rate.
  • The interest expenditure is computed by multiplying the discount rate by the amount of the lease liability that existed at the start of the period.
  • Depreciation Expense - Since the leased asset is fixed, it is subject to depreciation over the course of the lease. As a result, it is necessary for it to compute both the asset's useful life and, eventually, its salvage value.

Effect on Cash Flows

  • Cash Flow from Operations (CFO) is impacted (reduced) only by the proportion of lease payments that are classified as interest.
  • Cash flow from Financing (CFF) gets lowered since a portion of the lease payment is applied to the principal.

Understanding Capital Lease Accounting with Example

Consider this scenario:

  • Value of manufacturing equipment - $11,000
  • Useful life - 7 years
  • The asset's scrap value at the end of useful life - $0
  • Monthly lease payment (end of every month)- $200
  • Lease term - 6 years
  • Interest rate - 12%

We have to determine whether it's a capital lease to pass the capital lease journal entry in books.

To determine if this is a capital lease, one needs to look for the defining criteria.

  • When the lease term ends, the lessee takes over as the legal owner.
  • At the lease's expiration, the lessee has the option to purchase the underlying asset at a price lower than its current market value.
  • The lease term is more than or equal to 75% of the asset's productive economic lifespan.
  • For such a lease, the current value of the lease contract is greater than ninety percent of the asset's fair market value, which is leased out.
Financial accounting

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In the end, no ownership has changed hands. There is also no cheaper option to buy. The criteria are met because the lease is for six years, and the useful life is seven. 

The current value of $200 monthly payments must be determined for the fourth criterion. The present value multiplied by the lease payment amounts to $1,033, which is larger than 90% of the asset’s fair value. Hence, it's a capital lease. 


  • Number of months = (6*12=72 months)*Current value of minimum lease payment= $1,033
  • Depreciation= ($11,000/7) = $1,571
  • Interest for the first month at 1% of the current value = $10
  • Lease liability- interest expense= 200-10 = $190. 

Final Thoughts

With the shift from ASC 840 to ASC 842, lease accounting has undergone major revisions. For instance, a leased asset may be classified as either a capital lease or an operational lease based on additional criteria introduced.

Therefore, companies must leverage the latest lease accounting software solutions that incorporate all the latest GAAP requirements. 

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