Definition
A capital lease can also be referred to as a finance lease. It’s is an agreement in which the lessor agrees to transfer the sole ownership of an asset to the lessee upon the expirations of lease tenure. Moreover, once the lease tenure is about to expire or expire, it is upon the lessee’s will, if not stated in the agreement, to purchase the asset or property at a lower price than its market value.
Detailed Concept And Accounting for capital lease
A capital lease is a long-term agreement for using an asset; it is not cancellable. And if a capital lease is canceled due to unforeseen reasons, then according to the standard and agreements, the lessee has to bear the losses.
Furthermore, the ownership of an asset or the property can be transferred to the lessee. But this happens if the lease agreement is successful ends. Moreover, the price for the purchase of an asset at the end of the lease agreement must be less than the asset’s market value. In addition, to be classified as finance lease, the lease agreement should exceed 75% of the useful life of an asset.
The accounting treatment for Capital leases is different from that of operational leases. When it comes to accounting treatment, capital leases are then divided into interest payments and capital repayment to be recorded.
The payment of interest is charged in the incomes statement under the head of finance expenses. On the other hand, repayment of the principal is recorded in the balance sheet as liability repayment. Hence, the lease rental paid to the lessor is divided into two parts.
Accounting entries for the leases
Accounting treatment in terms of General entries being made in the book accounts for the year.
| Particulars | Debit | Credit |
| Present value of lease liability (At time of recording an asset) | Fixed Asset | Lease Liability |
| The interest portion of the payment | Interest Expense | Cash or Bank Account |
| The payment of the lease rental | Lease Liability | Cash or Bank Account |
| Asset disposal amount | Accumulated Depreciation | Fixed Asset |
Capital leases are reported as assets are purchased, and in every accounting period, we must also account for depreciation on the asset. Furthermore, if the sale price of an asset differs from its carrying cost at disposal, we use the sale proceeds to calculate the gain or loss for the year. Moreover, capital gains and losses are reflected in the Statement of Comprehensive income due to the difference. This is the same accounting treatment as in the case of the normally fixed assets.
Example for capital lease
Let’s say that company A agrees with Company-B to lease a machine. The lease term is for four years, and lessees must pay for the related maintenance expenses. The annual rentals amount to $8,000 payable at the inception date (advance rentals); the machine is expected to have a residual value and fair value amounting to $28,000. The cost of finance amounts to 10%.
Further, the total life of the machine is four years.
Let’s calculate the schedule for the payment of lease rentals.
Annual Lease Rental $ 8,000
Term of Lease 6 Years
Rate of Interest 10% Annually
Since the life of the finance, a lease is equal to the total life of the assets. Further, the maintenance of the machine is the responsibility of the lessee. Hence, it indicates the finance lease and lease liability should be amortized.
Further, the lease rentals have been paid in advance.
| S No | B/FWD | Advance rentals payment | Capital O/S | Interest (10%) | Cap repay | Carried forward |
| 1 | 28,000 | (8,000) | 20,000 | 2,000 | 6,000 | 22,000 |
| 2 | 22,000 | (8,000) | 14,000 | 1400 | 6,600 | 15,400 |
The lease schedule is continued till the end of the leased life of assets; It’s equally important to note that the proportion of the interest expense keeps decreasing, and capital repayment keeps increasing as we move forward in the lease life of assets.
Operating Lease Accounting
Accounting standards for leases have changed since 2019 for both IFRS and US GAAP. Under IFRS, capital and operating leases need to be recorded in the balance sheet. The finance lease is recorded as the traditional way of accounting. However, operating leases need to be recorded as a right to use the assets in the business’s balance sheet.
capital Lease Vs. Operating Lease
| Financial Lease | Operating Lease |
| It is a long term concept | It is a short term concept |
| The ownership is transferred | The ownership is not transferred |
| It is a long term agreement | It is a short term agreement |
| It is also known as a loan agreement. | It is also known as the rental agreement. |
| The lessee is responsible for the maintenance of the asset. | The lessor is responsible for the maintenance of the asset. |
| Cancellation falls upon the part of the lessee. | Cancellation falls upon the part of the lessor. |
| The risk of obsolescence falls upon the part of the lessee. | The risk of obsolescence falls upon the part of the lessor. |
| Option to the lessee for purchasing the asset. | There is no such option for the lessee to enjoy. |
Conclusion
A capital lease or finance lease is a long-term contract between lessor and lessees. The lessee obtains assets for a major asset life and records them in the balance sheet. The lessees calculate depreciation on the leased asset, the same as in the case of the owned fixed assets.
On inception, the finance lease is recorded against the liability which is the present value of the lease rentals. Further, lease rental is classified into two parts that include interest payment and capital repayment under lease rentals.
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