What Is A Capital Lease?
It would be more appropriate to begin to refer to capital leases in the past tense, as under ASC 842 lease accounting standard, the term ‘capital lease' is now obsolete.
Capital leases have effectively been rearranged and re-named ‘finance leases'. They are essentially the same thing as a capital lease in everything but name. A lease is a contract entitling a renter, also known as the lessee, to the temporary use of an asset. A capital lease has the economic characteristics of asset ownership for accounting purposes because the contract closely resembles the purchase of an asset. To be formally recognized as a capital lease, a lease has to meet at least one of these criteria (under the term ‘capital lease', this list was known as a “bright line test”. Under the new term ‘finance lease', that title is no longer valid.):
- Ownership of the asset in question is transferred at the end of the term of the lease
- The lessee is reasonably certain they will exercise a purchase option at the end of the term of the lease
- The lease term is 75% of the economic life of the underlying asset (now with finance leases the term has to be a “major part” of the economic life of the asset)
- The present value of lease payments is 90% of the fair value of the leased asset (now the present value has to be substantially all of the fair value of the leased asset)
With the advent of the term ‘finance lease' to replace ‘capital lease', there is an additional criterion that can be the defining characteristic of a finance lease: the leased asset has no alternative use to the lessor at the end of the lease.
What Is Capital Lease Accounting?
As of the implementation of ASC 842, capital lease accounting under the term ‘capital' is no longer performed, but the calculations under the new title ‘finance lease' remain the same.
How Are Capital Lease Payments Accounted For?
Capital leases are examples of accrual accounting's inclusion of economic events in finances. In other words, companies are required to calculate the present value of a certain obligation in their finances. So, since capital leases are financing arrangements, a company has to break down its periodic lease payments into interest expenses based on the company's applicable interest rate and depreciation expense in order to properly document the economic event that is a capital lease. Finally, a company must depreciate the leased asset in a way that factors in salvage value and useful life. This is done using the straight-line depreciation method.
The steps to book a journal entry for a capital lease (now a finance lease) are as follows:
- Make sure the lease is actually a capital lease (or a finance lease)
- Book a lease liability and right-of-use (ROU) asset by calculating the present value of all lease payments to be made over the determined period of the lease. The ROU asset will be further adjusted for any initial direct costs paid and incentives received.
- Using future lease payments, such as monthly rents, calculate the total straight-line monthly expense.
- Separate the straight-line monthly expense into two categories: the imputed interest paid and the amount amortized against the principal value.
- The lease liability is then calculated each month as the present value of future payments.
- Expense the interest portion through a profit-and-loss account each month.
- Reduce the ROU Asset by recording an amortization expense each month, which also flows through the profit and loss account.
