In today’s blog post, we will discuss and explain capital lease accounting. We will utilize a detailed example to illustrate the accounting entries involved, but let us stress that this example covers capital lease accounting under CURRENT lease accounting rules by the FASB and IASB –Topic 840/FAS 13 and IAS 17 respectively. In a subsequent blog post, we will address “Finance” lease accounting under the NEW Lease Accounting Rules issued by the FASB and IASB—Topic 842 and IFRS 16, respectively (under Topic 842, capital leases will be called finance leases).
As a refresher, a capital lease is one in which a lessee records the leased asset as if it purchased the asset using funding provided by the lessor. As a result, capital lease accounting under current GAAP is actually comprised of two transactions: A purchase of the underlying asset by the lessee AND a loan to the lessee from the lessor to fund the purchase of said asset.
A lessee should record a lease as a capital lease and therefore apply capital lease accounting if ANY of the following criteria are met:
- First Criterion: Ownership of the underlying asset transfers to the lessee after the lease term; or
- Second Criterion: There is a “bargain purchase option”, meaning that the lessee has an option to buy the underlying asset after the lease term at a price that’s below-market; or
- Third Criterion: The lease term is 75% or greater than the useful life of the underlying asset; or
- Fourth Criterion: The present value of the minimum lease payments is at least 90% of the fair value of the asset.
At this point we’d like to give a MAJOR SIDENOTE: Here at LeaseQuery, we like to call capital leases that meet either the first or second criterion “strong-form” capital leases and those that meet only the third or fourth criterion “weak-form” capital leases. This is because there is ONE MAJOR DIFFERENCE between those types of leases. For capital leases that transfer ownership at the end of the lease term and those that have a bargain purchase option (strong-form capital leases), the underlying assets are depreciated over the useful life that would be assigned if the asset were owned. For weak-form capital leases (those that meet only the third or fourth criterion), the assets would be depreciated over the lease term. This is a subtle difference, but it obviously has profound accounting implications.
Please note that LeaseQuery offers a FREE LEASE ACCOUNTING TOOL that helps you determine if your lease is a capital or operating lease. Here's our capital vs operating lease test. Once again, it’s completely free.
Now that we’ve had our refresher, let us address capital lease accounting under current rules using an actual example:
Assume a company (lessee) signs a lease for a forklift with the following predicates:
- Fair value of the forklift is $16,000
- Lease term is 3 years
- Monthly payments of $500/month paid in advance; $50 of the monthly payment is related to maintenance
- Interest rate a bank would charge this company for a $16,000 loan over 3 years is 4%
- Useful life of the forklift is 5 years
- At the end of the lease term, the company can purchase the forklift for $1,000, which is the estimated fair value at the end of the lease.
First, we need to perform the capital versus operating lease test: There is no title transfer at lease end, so the first test for capital lease accounting is not met. There is also no bargain purchase option (since the purchase option price is the same as the fair value at lease end), so the second test for capital lease accounting is not met. The lease term is 3 years while the useful life is 5 years. 3 years is less than 75% of 5 years (3 versus 3.75), so the third test for capital lease accounting is not met.
In order to perform the fourth test, we need to calculate the present value of the minimum lease payments. This is calculated as the present value of monthly payments of $450 over 3 years at 4%. Why are we using $450 instead of the full monthly payment of $500? Well, the $50 related to maintenance is deemed an “executory cost,” which is NOT considered part of the minimum lease payments and as such is excluded from the present value calculation.
This gives us a present value of $15,292.65, which is greater than 90% of the fair value of the asset (90% of $16,000 is $14,400). As a result, this is a capital lease per the fourth test, and as such capital lease accounting needs to be applied. Note: Click here for a blog showing how to use excel to calculate the present value of lease payments. Also, Click here for a free present value tool that actually performs the calculation for you.
The following schedule is an image of the lease amortization schedule used to record the journal entries under capital lease accounting:
We now have all the information we need to record the initial journal entry: As documented above, the present value of the minimum lease payments is $15,292.65; so the initial journal entry to record the capital lease is:
|Capital Lease Asset||15,292.65|
|Capital Lease Liability||15,292.65|
In the first month, two entries need to be recorded; one to record the payment of the lease, and the second to record depreciation expense. Because this is a “weak-form” lease, it is depreciated over the lease term of 3 years (36 months).
|Capital Lease Liability||450.00|
Note that because the first cash payment is made at the beginning of the lease term, there is no interest to be recorded. $50 of the payment is recorded as maintenance expense, while the entire remaining balance of $450 goes directly to reduce the liability. The following journal entry represents the entry for depreciation expense, which will not change throughout the lease:
In the second month, the lessee will make the following entries to record payment on the capital lease:
|Capital Lease Liability||400.52|
Note that in the second month, a portion of the payment the lessee makes goes against interest expense, a portion goes to maintenance expense to cover executory costs, while the remaining balance goes to reduce the capital lease liability. These numbers are easily obtained from the amortization schedule above.
In a subsequent blog post we will address how to account for early termination of a capital lease under current lease accounting rules governing capital lease accounting. In that post, we will continue with this example so that we can come full circle.
Finally, we have a guide helping companies transition to the new lease standard. Click here to download your copy today!