The first question any accountant should ask when presented with a lease agreement is, “whether this is a capital or an operating lease.” There are a few factors in the structure of a lease that determine its classification. Capital and operating leases are in fact very different.
Let’s start with the operating lease. Currently under US GAAP, all leases are operating leases unless they meet one of four criteria for classification as a capital lease. Many companies try to structure their leases as operating leases. The liability created by the lease does not have to be recorded on the balance sheet; rather the monthly payments are expensed on the income statement. The journal entry is:
DR. Rent/Equipment/Lease Expense
Capital leases, on the other hand, are a little more complicated. If a lease meets one or more of the following criteria, it is considered a capital lease:
- The term of the lease is 75% or greater of the useful life of the equipment.
- There is a bargain purchase option at the end of the lease.
- Ownership is transferred at the end of the lease.
- The present value of the lease payments is 90% or greater than the fair market value of the equipment.
As implied by the name and the criteria above, a capital lease can only apply to leases involving capital assets. Capital assets include items such as vehicles, computer hardware, machinery, etc.
There are four important parts of the lease agreement: the total lease amount, the terms, the interest rate, and the monthly payment amount. When a lease agreement is signed for a capital lease, the liability is recorded on the balance sheet along with the asset acquired through the contract for the amount of the total lease.
DR. Fixed Asset
CR. Lease Liability
Each month, the liability is reduced when the payments are made. Typically, a company will create a lease amortization schedule to determine the portion of each monthly payment that is applied to the principle liability and which portion is interest.
DR. Lease Liability (principle portion)
After the payments are recorded each month, one more journal needs to be recorded: depreciation of the asset. The depreciable period is the useful life of the asset and not the terms of the lease. The monthly accounting for a capital lease can be complicated without referencing the original source documents.
While most companies prefer to deal with operating leases, over the last few years the accounting standards board has been leaning toward eliminating operating leases as a valid structure and accounting method. Because the lease does not have to be recorded as a liability, companies can have large obligations that are not represented on traditional financial statements. To create more transparency in financial reporting, the board is moving toward using the capital lease accounting method for all lease agreements. Ensure your leases are recorded properly. Contact your CPA or accounting advisor, like TGG Accounting, for help when recording these transactions.Written by: Ashley Peth TGG Accounting