Lease Accounting: Capital versus Operating

What is a lease?

A lease is a contract that gives you the right to use an identified asset (such as a vehicle, copier, etc.) for a period of time in exchange for other considerations (like cash).

There are two types of leases: capital and operating. In this blog, we will take a look at leases from a lessee’s perspective.

What is a capital lease?

A lease is a capital lease if any of the following criteria are met at inception:

Transfer of Ownership |At the end of the lease, you will own the asset. In other words, you financed the asset with a lease.

Bargain Purchase Option | At the end of the lease, you have the option to buy the asset below the fair market value.

For example if your lease includes the option to purchase the asset for $1.00 (it’s common), that’s a bargain purchase option and the lease would be considered a capital lease.

Lease Term | The lease term is equal to 75% or more of the estimated economic life (that is…how long you will be able to use the asset with normal repairs and maintenance).

For example if the lease term is four years and the life is five years, the lease term is equal to 80% of the estimated economic life and the lease would be considered a capital lease.

Lease Payments | The present value of the minimum lease payments is equal to 90% or more of the fair market value of the asset at inception. Here’s an example:

The lease term is five years. Monthly payments of $1,200 are due in advance (at the beginning of the month). The borrowing rate is 6%. The present value of the lease payments is $62,381. If the fair market value of the asset is $56,143 or greater, the lease would be considered a capital lease.

How do you calculate present value?

Use Excel’s present value formula (=PV(rate, nper, pmt, [fv], [type]).

Rate: 6%/12 or .05% (interest rate divided by frequency)

Nper: 5*12 or 60 (term multiplied by frequency)

Pmt: $1,200

[FV]: Always enter zero

[Type]: 1 (1 if the payment is due at the being of the period or 0 if the payment is due at the end of the period)

=PV(.05%, 60, 1200, 0, 1) = $62,381

How do you account for a capital lease?

Going back to the example above (assuming it was determined to be a capital lease), at the inception of the lease you would record an asset and a corresponding capital lease liability.

 

Account Debit Credit
Asset $62,381
Capital Lease Liability $62,381

When you make payments, you will record the payment along with depreciation and interest expense.

 

Account Debit Credit
Accumulated Depreciation $1,040
Depreciation Expense $1,040*
Cash $1,200
Interest Expense $31**
Capital Lease Liability $1,169

*Depreciation expense was calculated using the straight-line method ($62,381/60 = $1,040).

**Interest expense is calculated based on the capital lease liability balance multiplied by the interest rate for the period ($62,381*.05% = $31). Each payment will reduce the capital lease liability balance. Therefore, you will need to refer back to your amortization table (that’s a schedule that tells you the principle and interest portion of each payment).

What is an operating lease?

That’s an easy one…any lease that doesn’t meet the criteria of a capital lease.

 How do you account for an operating lease?

Going back to the example above (assuming it was determined to be an operating lease), as you make the payments, you will record a rental expense.

 

Account Debit Credit
Expense $1,200
Cash $1,200

Changes are coming…

And because we are nice, we want to give you a heads up that the lease accounting standards are changing. You have some time to implement (if you are a calendar year-end, the new standard will be effective on 1/1/2019 and 1/1/2020 for public and private companies, respectively).

What’s changing?

Leases will be classified as financing, operating or short-term.

Financing Leases | These leases have similar criteria to capital leases. In addition, the accounting is effectively the same. However, you will be recording a right to use asset and finance lease liability.  See capital lease example above.

Short-Term Leases | These are leases with terms less than 12 months (unless there is an option to renew and the renewal is reasonably certain).  The accounting for short-term leases will be the same as the previous operating lease category. See the operating lease example above.

Operating Leases | These will be leases that don’t meet the requirements of financing or short-term. The accounting for operating leases will require you to record a right to use asset and an operating lease liability.

Going back to the example again (assuming it was determined to be an operating lease under the new standard), at the inception of the lease you would record a right to use asset and a corresponding operating lease liability.

 

Account Debit Credit
Right to Use Asset $62,381
Operating Lease Liability $62,381

When you make payments, you will record the payment along with depreciation and interest expense.

 

Account Debit Credit
Accumulated Depreciation, Right to Use Asset $1,040
Depreciation Expense $1,040*
Cash $1,200
Rent Expense $160**
Operating Lease Liability $1,040**

*Depreciation expense was calculated using the straight-line method ($62,381/60 = $1,040).

**The operating lease liability will be reduced over the life of the lease using the straight-line method ($62,381/60 = $1,040). Rent expense is calculated based on the payment amount less the operating lease liability portion ($1,200-$1,040 = $160).

How do you account for an operating lease under the new standard?

Going back to the example above (assuming it was determined to be an operating lease under the new standard), at the inception of the lease you would record a right to use asset and a corresponding operating lease liability.

 

Account Debit Credit
Right to Use Asset $62,381
Operating Lease Liability $62,381

And when you make payments, you will record the payment along with depreciation and interest expenses.

 

Account Debit Credit
Accumulated Depreciation $1,040
Depreciation Expense $1,040*
Cash $1,200
Rent Expense $160**
Operating Lease Liability $1,040**

*Depreciation expense was calculated using the straight-line method ($62,381/60 = $1,040).

**The operating lease liability is reduced using the straight-line method ($62,381/60 = $1,040). The rent expense is calculated by subtracting the current portion of the operating lease liability from the total payment ($1,200-$1,040).

Want to know more or need help…

We know this accounting stuff can be a headache. Reach out to your business advisor, audit or tax professional if you need help. If you don’t have one, we have plenty of them that love this stuff.

Want to know more on this topic? Click here for a more in-depth take on the topic.

 

 

 

 

 

 

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