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How do Business Owners account for Capital Lease Transactions?

Guest post by: Stan Prokop

Article Overview: The article provides information into the methods and importance of accounting for equipment leases with reference to Capital lease type transactions .

How do Business Owners account for Capital Lease Transactions?

Most business owners know that there are two types of leases they can enter into when acquired equipment for their businesses. Those two types of leases are capital leases and operating leases. We will focus on the Capital Lease for the purposes of our discussion.

When the business selects a capital lease transaction then the transaction is ‘capitalized’ on the company financial statements. There are two parts to this capitalization process – first the asset is recorded on the balance sheet as a fixed asset, and at the same time the firm records a liability for the lease on the Liability section of the balance sheet.

There is an imported related transaction on the customer’s income statement. (Business owners know there are three parts to a financial statement, the balance sheet, the income statement, and the cash flow statement. Getting back to our transaction, the income statement is used in our lease transaction to expense the interest that the company is paying on the lease. That relates to one of the main benefits of leasing, which is the ability of the business to expense the interest. Business owners are cautioned to always ask their lessor for an ‘amortization’ of the lease, this will show them very clearly how much they can expense on the interest charged by the lessor in the lease.

As a final part of the transaction the company needs to determine the length of time over which they will depreciate the asset, which is also recorded on the income statement.

Let’s focus in on the clear three step accounting process to record our transaction:

1. Capitalize the lease on the asset and liability portion of the balance sheets. Take the present value of the lease payments and also ensure not to exceed the fair market value of the equipment.

2. Depreciate the asset in a consistent manner. The company should use their normal deprecation policy for this type of asset. ( Note ** There are different classes of assets with different depreciation rates )

3. Amortize the lease in a way in which a loan is recorded on your firm’s books. This has the effect of separating the principal payments and the interest expense attached that payment.

Business owners should ensure they have in fact not entered into an operating lease agreement, under which they would have no right to classify the equipment as an asset – in the operating lease scenario they are using the equipment, not paying to own it at the end.

In summary, a company needs to understand how to account for leases, especially if they use this tool as a long term financing vehicle. Proper accounting allows the firm to maximize reporting benefits and ensure they are maximizing the true benefits of a lease transaction.

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Article Tags: capital leases, lease accounting



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