Capital Lease Accounting

What is a Capital Lease?

Capital lease accounting deals with the treatment of an asset rented by a business under the terms of a capital lease agreement.

A capital lease or finance lease is an agreement between the business (lessee) to rent an asset from a lessor. The lessor (lease company, finance company etc.) owns the asset, and the business rents the asset in return for a periodic rental payment. The business never owns the asset, at the end of the term it is returned to the lessor or a secondary period of rental is entered into.

The legal form of a capital lease is that the business never owns the asset, however because under a capital lease the rights and risks of ownership are transferred to the business, for accounting purposes the substance of the agreement is reflected and the asset is treated like any other asset, as if it had been purchased by the business.

In effect the capital lease accounting treatment deals with asset as it it had been purchased using a loan as finance. The asset is depreciated as normal over the term of the agreement, and the rental payments are split between principal and interest to clear the loan balance over the term, and to charge the profit and loss account with the interest.

Capital Lease Accounting Example

Suppose a business enters into a capital lease agreement for an asset worth 12,000 and agrees to pay a deposit of 1,500, leaving a balance of 10,500 to be financed by a capital lease with an implicit annual interest rate of 7% requiring a further four annual rental payments of 3,100.

The total amount paid in rentals over the term is 4 x 3,100 = 12,400. This amount can be split into the original amount financed of 10,500, known as the principal amount, and the interest charge of 12,400 – 10,500 = 1,900. Under capital lease accounting, the rentals are paid to clear the capital lease principal and interest over the term of four years.

The analysis of the Capital Lease Accounting is shown below:

Allocation of Interest to Accounting Periods

The first step in capital lease accounting, is to decide how to allocate the interest charge over the term of the agreement. In the above example, the total interest charge is 1,900 over a four year term.

Each rental payment will pay an element of principal and interest. If the interest accrued evenly over the term then each rental payment would comprise one quarter of the total principal and one quarter of the total interest. In the above example, each of the four rental payments would be split as follows.

Rental payment = Capital / 4 + Interest / 4
Rental payment = 10,500 / 4 + 1,900 / 4
Rental payment = 2,625 + 475 = 3,100

However, the interest does not accrue evenly, as the payments are made the amount outstanding falls causing the interest in later years to be lower than earlier years.

The payment schedule below shows how the interest charge changes for each year.

Using the interest amounts from the table above, each rental payment can be split between principal and interest as follows.

The principal and interest amounts are used in capital lease accounting journal entries to record the rental payments.

Our free excel calculator to help calculate the monthly rental payment principal / interest split is available for download here.

Capital Lease Accounting Journal Entries

The capital lease accounting journal entries are in three parts.

1. To record the effective purchase of an asset using a loan.
2. To record the periodic depreciation charge.
3. To record the periodic rental payments to clear the principal and to charge the profit and loss account with the interest.

To record the effective purchase of an asset using a loan.

The capital lease accounting journal shows how the asset is recorded as if it had been acquired by the business, the deposit is paid using cash, and finally the liability under the capital lease for the outstanding principal amount is recorded.

To record the periodic depreciation charge.

The depreciation charge on the asset acquired with a capital lease is calculated the same as for any other asset. The asset must be depreciated over the shorter of the useful life of the asset and the term of the lease. For further explanation our tutorials on depreciation can be viewed here.

In this case assuming straight line depreciation, the annual charge is calculated as follows.

Depreciation = Asset Value / Term = 12,000 / 4 = 3,000 per year
Depreciation = 12,000 / 4 = 3,000 per year

The capital lease accounting journal entry for depreciation is then as follows:

This capital lease accounting  journal will occur for each of the four years until the asset is depreciated to zero.

To record the periodic rental payments

The capital lease journal entry for each rental payment will be different as the split between principal and interest changes.

As an example the journal below shows the rental payment for year 1.

This capital lease accounting journal shows the posting of the first rental payment, the amount of 3,100 is paid in cash, the lease liability is reduced by the principal element of the payment, and the interest is charged to the profit and loss account.

Each year a payment is made, the principal and interest will change as shown in the table above, but at the end of the four years, interest of 1,900 will have been charged to the profit and loss account, and the lease liability will have been reduced to zero.

Free Excel Capital Lease Accounting Calculator

A free excel calculator to help calculate the monthly rental payment principal / interest split is available for download here. This calculator will also produce the capital lease accounting journal entries.

In summary, accounting for capital leases is the same as dealing with an asset purchase using a loan (although the business never legally owns the asset). The asset is depreciated as normal over the term of the agreement, and the rental payments are split between principal and interest to clear the loan balance over the term, and to charge the profit and loss account with the interest.

A capital lease is only one form of lease, an operating lease is normally used for short term rentals.