A capital lease is a lease in which the lessee records the underlying asset as though it owns the asset. This means that the lessor is treated as a party that happens to be financing an asset that the lessee owns. The lessor should record a lease as a capital lease if any of the following criteria are met:
- The lease period covers at least 75% of the useful life of the asset; or
- There is an option to buy the leased asset following the lease expiration at a below-market rate; or
- Ownership of the leased asset shifts to the lessee following the lease expiration; or
- The present value of the minimum lease payments totals at least 90% of the fair value of the asset at the beginning of the lease.
The lessor and lessee typically agree upon lease conditions in advance that will designate a lease as an operating or capital lease; the outcome of the lease analysis is rarely accidental.
If an examination of these criteria indicate that a leased asset is a capital lease, the accounting for the lease is comprised of the following activities:
- Initial recordation. Calculate the present value of all lease payments; this will be the recorded cost of the asset. Record the amount as a debit to the appropriate fixed asset account, and a credit to the capital lease liability account. For example, if the present value of all lease payments for a production machine is $100,000, record it as a debit of $100,000 to the production equipment account and a credit of $100,000 to the capital lease liability account.
- Lease payments. As the company receives lease invoices from the lessor, record a portion of each invoice as interest expense and use the remainder to reduce the balance in the capital lease liability account. Eventually, this means that the balance in the capital lease liability account should be brought down to zero. For example, if a lease payment were for a total of $1,000 and $120 of that amount were for interest expense, then the entry would be a debit of $880 to the capital lease liability account, a debit of $120 to the interest expense account, and a credit of $1,000 to the accounts payable account.
- Depreciation. Since an asset recorded through a capital lease is essentially no different from any other fixed asset, it must be depreciated in the normal manner, where periodic depreciation is based on a combination of the recorded asset cost, any salvage value, and its useful life. For example, if an asset has a cost of $100,000, no expected salvage value, and a 10-year useful life, the annual depreciation entry for it will be a debit of $10,000 to the depreciation expense account and a credit to the accumulated depreciation account.
- Disposal. When the asset is disposed of, the fixed asset account in which it was originally recorded is debited and the accumulated depreciation account is credited, so that the balances in these accounts related to the asset are eliminated. If there is a difference between the net carrying amount of the asset and its sale price, it is recorded as a gain or loss in the period when the disposal transaction occurred.
In short, the accounting for a "normal" fixed asset and one acquired through a lease are the same, except for the derivation of the initial asset cost and the subsequent treatment of lease payments.