A lease is a contract between two parties that allows one party, the lessee, to use the assets of the other party, the lessor, in exchange for periodic payments. Usually, leases last for a prespecified amount of time. A lease agreement can mutually beneficial for both parties, the lessor and the lessee.
Legally, there is no transfer of an asset from one party to another at the start of the lease agreement. However, in economic and accounting terms, some leases may be treated as if a transfer had occurred. The treatment is subject to certain conditions.
Capital Lease
A capital lease is a long-term lease that, in accounting, is treated as if the lessee has owned the asset rather than leased it. It is because, in this type of lease, the lessee bears the risks and rewards of the leased asset. Hence, capital lease assets take the form of owned assets rather than leased ones.
Capital lease requires the lessee to record the leased asset as a fixed asset. The lessee must also charge depreciation on the capital lease asset. Similarly, it requires the lessee to recognize the lease payments as finance costs.
There are certain checks that the lessee must perform to determine whether a lease qualified as capital lease as opposed to an operating lease. These checks are necessary to establish whether the lessee or the lessor has to bear the risks and rewards of the asset.
The current rule to determine whether a lease qualifies as a capital lease is to establish whether the lease term is above one year. If a lessee leases an asset for more than a year, it will qualify as a capital lease.
Capital Lease Obligation
Every lease agreement requires lessees to make certain payments to the lessor. These payments are known as lease obligations. Capital lease obligation consists of compensations, such as rent of the leased asset, hire charges, etc. that lessees must pay to the lessor in exchange for a capital asset under a capital lease.
These obligations are aggregated at the start of the lease agreement and discounted to their present value.
Every payment that the lessee makes to the lessor will consist of two components. The first component will be the principal amount of the lease deducted from the capital lease obligation in the Balance Sheet.
The second component will be the interest payment on the lease, which results from unwinding the capital lease obligation. This interest payment qualifies as a financial expense in the financial statements of the lessee.
Finally, the lessee must also divide the capital lease obligation into non-current and current components based on how soon the payments are due.
Example
A company, ABC Co., leases machinery from XYZ Co. for a total of 5 years. As per the lease agreement, ABC Co. must pay XYZ Co. $10,000 at each year-end as a part of the lease. Since the lease is for more than one year, ABC Co. must treat it as a capital lease.
To record the capital lease obligation, ABC Co. must first find the present value of the lease obligation. ABC Co. takes a discount rate of 10% for this purpose. The calculation will be as follows.
| Year | Cash flow ($) | Discount factor | Present value ($) |
| 1 | 10,000 | 0.909 | 9,090 |
| 2 | 10,000 | 0.826 | 8,260 |
| 3 | 10,000 | 0.751 | 7,510 |
| 4 | 10,000 | 0.683 | 6,830 |
| 5 | 10,000 | 0.621 | 6,210 |
| 37,900 |
Therefore, ABC Co. will record a capital lease obligation of $37,900 rather than $50,000. The accounting entries will be as follows:
Dr Machinery $37,900
Cr Capital lease obligation $37,900
At the end of each year, ABC Co. will calculate the interest on the capital lease obligation using the discount factor of 10% and then record the payment made to XYZ Co. For example, for the first year, the accounting entries will be:
Interest on capital lease obligation
Dr Finance cost ($37,900 x 10%) $3,790
Cr Capital lease obligation $3,790
Lease payment made to XYZ Co.
Dr Capital lease obligation $10,000
Cr Cash $10,000
In the 2nd year, ABC Co. will calculate the lease interest on the remaining capital obligation balance, which is $31,690 ($37,900 + $3,790 – $10,000). ABC Co. will continue the same accounting for the next four years of the lease until there is no remaining balance in the capital lease obligation account.
For XYZ Co., the same accounting treatment will apply. However, instead of a capital lease obligation, it must recognize a capital lease receivable. Similarly, XYZ Co. will record the interest generated from unwinding the receivable as a finance income.
Conclusion
A lease agreement has two parties, a lessee and a lessor. Leases allow lessees to obtain an asset from lessors without having to purchase them. A capital lease is a type of lease that lasts more than 12 months.
Accounting rules treat capital leases as if the lessee owns the asset rather than leases it. In a capital lease, the lessee must calculate and record a capital lease obligation, which is the present value of all lease payments.
