Accounting for Capital Leases

  
 

Accounting for Capital Leases

In the case of a capital lease as determined by the criteria discussed above, the lessee is considered to have purchased the asset and has a corresponding liability to pay. This is similar to the treatment of loans.

Let's have a look at an example. A company leases machinery for a lease period of 30 months. The lease payments are $300 per month for the 30 months, after which the company can buy the equipment for $1. The estimated value of the equipment is $750 after three years.

This lease is a capital lease because of the bargain purchase option. The lessee is almost guaranteed to buyout the lease at the end of the term because the equipment is worth more ($750) than what has to be paid ($1).

A capital lease means you must treat the asset as if you purchased it. You therefore have to determine the value of the equipment. The value of the equipment is the present value of the lease payments. (Stay with me; it's not as nasty a concept as it seems.)

If you were the lessee in the example above, you would have to pay $300 per month for 30 months; however, this payment would include interest: let's say 12 percent annual interest (or 1 percent per month). Therefore, when you back out the interest portion, you get the total amount of principal payments on the lease. It's like a backwards amortization table. You can figure out the principal portion of a lease by using a present value of annuity table. The relevant section of such a table for this example is

 

 Period

 

Discount Rate

 

 

1%

2%

3%

 28

24.316

21.281

18.764

 29

25.066

21.844

19.188

 30

25.808

22.396

19.600

 

When we take the monthly payment and multiply it by the fac­tor in the table, we get:

                                $300 X 25.808 = $7,742.40

The accounting to reflect this capital lease is ­

            DR     Capital assets                                  $7,742.40

            CR     Capital lease obligations (liability)               $7,742.40

 

Once the value of the asset is determined using the present value table, an amortization schedule can be developed to determine how much of the monthly payments represents principal repayments and how much represents interest expense. The entry to account for the monthly payment would look like this:

DR Capital lease obligations

DR Interest

CR Bank