Accounting for Capital Leases

Leases are a common method for organizations to obtain capital assets. Virtually any asset that can be purchased can also be leased, including vehicles, furniture and office equipment. In addition, most organizations lease office space.

The two most common types of leases are operating and capital leases. The conceptual difference between these types of leases is that with a capital lease you are in effect purchasing a capital asset, while with an operating lease you are paying a fee for temporary use of an item.

Frequently, leases of office equipment are capital leases, while office space and vehicle leases are operating leases. However, each lease must be analyzed individually.

A lease should be classified as a capital lease if any one of the following conditions is met:

• Ownership of the asset automatically transfers to the lessee at the end of the lease term.
• The lease contains a bargain purchase option.
• The term of the lease is for 75% or more of the estimated economic useful life of the asset.
• The present value* of the minimum lease payments is 90% or more of the fair value of the asset.

* The lessee should calculate the present value using its own incremental borrowing rate, unless (a) the lessee is able to determine the implicit rate, and (b) the implicit rate is lower than the incremental rate.

If none of these criteria are met then the lease should considered an operating lease.

If the lease is determined to be capital lease then the cost of the item purchased must be amortized over its useful life. This is similar to depreciating an item that you purchased outright. In order to properly amortize the leased item you will need to use an amortization table (click here for a copy).

To complete the amortization table you will need to know the monthly lease payment and the fair value of the item being leased. By entering these values into the amortization table you can calculate the portion of each monthly payment that is for principle and the portion that is for interest.

Journal Entries

The following are the entries necessary for an operating lease:

At Inception of lease:
NO ENTRY NEEDED

Each Month:
DR      Lease / Rental expense
     CR      Cash

This entry is made for the amount of the monthly lease payment

The following entries are necessary for a capital lease:

At inception of lease:
DR      Fixed assets account
     CR      Capital lease liability

This entry is made for the fair value of the property being leased

Each Month:
DR      Capital lease liability
DR      Interest expense
     CR      Cash

The debit to capital lease liability is made each month based on the amortization table. The interest portion is simply the difference between the cash paid and the monthly principal portion from the amortization table