Accounting for Capital Leases: Explanation and Example

Introduction

A capital lease is also known as a finance lease, allows an entity to own assets for a limited amount of time. The asset which is acquired through this process is also known as an owned asset. The person or entity which leases that asset is also responsible for its maintenance and a certain percentage of the profit that is to be shared between lessee and leaser.

The detailed conditions are highlighted under the lease agreement which is signed by both parties. Basically, the capital lease agreement allows a person or an entity to borrow capital from the person who is leasing that capital.

In accounting, the journal entry would show the leased capital as part of the asset of that particular company.

Explanation of a capital lease agreement

In accounting terms, a capital lease agreement is between two parties, where one of the parties borrows an asset and lets the other party use it. The borrowing must enter the associated value of the assets, and the associated liabilities with it in its accounting journal entries, which specifications are included in the contracts.

A capital lease has many benefits of an asset purchase, with fewer risks of completing owning an asset outright. There are a few risks associated with leasing an asset accounting-wise. If the asset does not produce enough or break down under the lease agreement, the accounting books of the leaser are badly affected. This is due to the fact that if an asset breaks down, the value of that asset has to be written down, while the liabilities stay the same on the book.

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This is why when making a lease agreement; the company must assess the risk side of leasing that particular asset on the balance sheet side for the company.

Example

Consider, for example, a company called A, which makes pins. The company wants to buy a new bending machine, but it does not have enough cash and the banks are not willing to lend to it. But, the company desperately needs a new bending machine. The company decides to lease a bending machine. The machine is worth five thousand U.S. Dollars.

The lease agreement puts the monthly payments at five hundred dollars with annual depreciation of four hundred dollars. How this is reflected in the balance sheet is given in Table 1 below:

PaymentsLiabilitiesInterestPrincipleDepreciation
5005000100400400
500450098402400
500400097403400
500350096404400

Table 1: How a balance sheet would be for Company A due to the lease agreement for the first five months

As stated before, and seen in Table 1, the liabilities are highest at the start. The balance sheet is for the first five months. Usually, the lease agreement would display the leases’ liabilities and other metrics until all the liabilities are cleared off. When all the liabilities are cleared, only depreciation would be recorded into the balance sheet of a company.

Criteria for a capital lease

The criteria for a capital lease are shown in figure 1.

Figure 1: The main criteria for a capital lease agreement

The four main criteria for a capital lease agreement are Ownership, lease term, present value, bargain purchase option. See the details of these criteria are given below:

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1 Ownership

The ownership of the underlying asset changes hand. Under the leasing agreement, for the duration during which the lease would last, the ownership would be shifted from the lease to the leaser.

This transfer of ownership is also reflected in the balance sheet. The balance sheet of the company which is leasing the asset shows that asset as it owns that asset in its balance sheet.

The ownership changes again when the lease agreement ends and then the ownership is transferred again to the original owner of that asset.

2 Lease term

The lease term can be defined as the length of the time for which the lease agreement is applicable. After the end of the lease term, the lease expires. The asset for which the lease was to be signed is transferred to the original owner. The usual time length for a lease agreement is based on the depreciation of the asset.

If the asset is absolutely new, the lease agreement is signed for a total time for when about seventy-five percent of the value of the assets is depreciated. The lease agreements can also be longer or shorter.

3 Present Value

The present value of a contract has is greatly affected by what is the present value of the asset. Is it a brand new asset or a very old asset? If it is an old asset, the contract or the lease agreement would not be for much longer, but if the asset is brand new the lease agreement would be for a longer timeline.

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For a new asset, the usual lease term is for when the value of the asset is depreciated to about seventy-five percent of its original value. So, the present value of an asset has a great impact on the lease agreement and it is considered as one of the most important criteria for the lease agreement.

4 Bargain Lease agreement options

At the end of a lease agreement, some leasers add an option to purchase the asset. The purchase of the asset usually happens below the market asking price or the real monetary value of the asset.

When an asset has depreciated seventy-five percent, the chances increase that no one would borrow or lease that asset again. So, the leaser would sell the asset at below market price to the original borrower of that asset.

Conclusion

Leasing agreements allow a company to borrow an asset and show it in its balance sheets as an owned asset. The accounting for capital leases allows the leased asset to be noted in the balance sheet as an asset completely owned by the company itself.

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