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.
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.
When a lease satisfies the following conditions, as specified in ASC 842, it is categorized as a capital lease and gets treated as such:
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:
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.
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).
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.
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.
Let's examine the effect of capital leases on the lessee's account.
Capital lease has two distinct implications on the balance sheet, both of which are important to understand.
Consider this scenario:
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.
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.
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.