Capital lease accounting example

NOTE: The FASB's current project to revise lease accounting may change some aspects of capital lease accounting.

Let's take as an example a copier lease. The copier costs $3000 to purchase new; the lessor is willing to lease it to you for 3 years at a price of $115 per month, paid at the beginning of each month. Of that, $16 is identified as the cost of maintenance. If you borrowed money for three years, you would have to pay 8.5% interest. If you bought the copier, you would normally depreciate it over 5 years. There is an option to buy the copier at the end of the lease for $500, which is estimated to be its fair market value at that time.

First, we check the four capital vs. operating tests. There is no ownership transfer as part of the lease agreement, so criterion #1 is not met. The purchase option is not a "bargain" as defined by FAS-13, so criterion #2 is not met. The lease term of 3 years is less than 75% of the economic life of 5 years, so criterion #3 is not met.

Determining the present value of the rents takes a few more steps. First, we eliminate the maintenance cost; that is considered an "executory cost," and excluded from this calculation. Thus, the net rent is $99 per month. At your incremental borrowing rate of 8.5%, the present value of the rent is $3,158.35, which is more than 90% of the fair value of the asset. Thus, criterion #4 is met and the lease is capital.

A lease cannot be capitalized at a higher value than the fair market value, so an interest rate must be calculated which will cause the present value of the rents at that rate to be equal to the fair market value of the asset. For this lease, the needed interest rate is 12.26%.

The first month, you set up an asset and an obligation, make the first rental payment, then accrue interest and depreciation:

Sample capital lease journal entries, first month

Account	Debit	Credit
Gross asset	3,000.00
Current obligation		902.25
Long term obligation		2,097.75
(Initial booking)
Current obligation	99.00
Executory expense	16.00
Cash		115.00
(Monthly rent payment)
Long term obligation	77.58
Current obligation		77.58
(Obligation transfer, long term to current)
Interest expense	29.63
Accrued interest		29.63
(Interest accrual for first month)
Depreciation expense	83.33
Accumulated depreciation		83.33
(Depreciation accrual for first month)

Note that the first rental payment, since it is made on the first day of the lease, goes entirely into obligation reduction. In following months, the interest accrued during the month is paid off by the rental payment, with the excess of rent over accrued interest going to obligation reduction. (In certain leases with scheduled rent increases, the rent paid may be less than the accrued interest. This results in an increase to the outstanding obligation, known as negative principal amortization.) For this lease, the journal entries for month #2's rent payment would be:

Current obligation	69.37
Accrued interest	29.63
Executory expense	16.00
Cash		115.00
(Month #2 rent payment)

Each month, the rent payment is booked in the manner shown above, depreciation and interest are accrued and expensed, and obligation is reclassified from long-term to current. When the lease expires (or if it is terminated before its scheduled expiration date), the asset and obligation are removed from the books, with a gain or loss recognized if the net asset and remaining obligation are unequal. This is almost always the case if the lease is early terminated. It may be the case with a normal expiration, most frequently when the lease conveys ownership or has a bargain purchase option, since the lease is then depreciated over its economic life, which is typically longer than the lease term, leaving an unamortized asset at expiration.

You also need to disclose your future rent commitments, as well as the portion of future rent that is considered executory costs and interest. At the end of the first year, for example, you have two years of $115 per month rent remaining. So as of the end of year 1, your disclosure would be:

The following is a schedule by years of minimum future rentals on noncancellable operating leases as of December 31, 20X7:

Year ending December 31,
20X8:	1,380
20X9:	1,380
Total minimum payments required:	2,760
Less executory costs:	384
Net minimum lease payments:	2,376
Less amount representing interest:	278
Present value of net minimum lease payments:	2,098

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Operating lease accounting is considerably simpler, but has its own complications; see an example of that as well.