Quite a while ago, the term ‘capital leases’ was dropped by FASB.

With the advent of ASC 842 back in 2021, capital leases underwent a title change. Not too big of a deal, but if you’re having troubles with accounting for capital leases—or, as they’re now called, finance leases—stick around for a discussion on what’s changed and what hasn’t (hint: it’s really just the name) and for a step-by-step of how to calculate and record capital lease journal entries.

What is a Capital Lease?

It would be more appropriate to refer to capital leases in the past tense, as under the new ASC 842 lease accounting standard, the term ‘capital lease’ was rendered obsolete. Capital leases have effectively been re-named ‘finance leases.’ However, finance leases are essentially the same thing as a capital lease in everything but name.

A lease is a contract entitling a renter, also known as the lessee, to the temporary use of an asset. What was a capital lease and is now a finance lease has the economic characteristics of asset ownership for accounting purposes, because the contract closely resembles the purchase of an asset.

What is Accounting for Capital Leases?

As of the implementation of ASC 842, accounting for capital leases under the term ‘capital’ is no longer performed, but the calculations under the new title ‘finance lease’ remain the same. 

What Were the 4 Rules for a Capital Lease?

In order to be formally recognized as a capital lease, a lease had to meet at least one of the following four criteria, not five:

• Ownership of the asset in question is transferred at the end of the term of the lease
• The lessee is reasonably certain they will exercise a purchase option at the end of the term of the lease
• Now with finance leases, the term has to be a “major part” of the economic life of the asset, but under a capital lease, the lease term was 75% of the economic life of the underlying asset
• With finance leases, the present value of lease payments has to be substantially all of the fair value of the leased asset, but for capital leases, the present value of lease payments was 90% of the fair value of the leased asset 

Under the term ‘capital lease,’ the last two rules on this list were known as a “bright line test.” Under the new term ‘finance lease,’ that title is no longer valid unless the lessee makes the policy election to retain the bright lines.

How Did the Rules Change With the Switch from Capital Lease to Finance Lease? 

With the advent of the term ‘finance lease’ to replace ‘capital lease,’ there is one additional criteria that is added to the list of the defining characteristics of a finance lease. This addition is that the leased asset has no alternative use to the lessor at the end of the lease.

What Was Accounting for Capital Leases?

A properly recorded capital lease should have both the lease asset and the lease liability present on the balance sheet. The lease asset needs to be amortized over the useful life of the lease period. Regardless of the timing of actual lease payments, the lease needs to be amortized and the interest needs to be recognized on the financial statements.

How Were Capital Lease Payments Accounted For?

Capital leases were examples of accrual accounting’s inclusion of economic events in finances. In other words, companies were required to calculate the present value of a certain obligation in its finances when they accounted for capital leases.

Since capital leases were financing arrangements, a company had to break down its periodic lease payments into interest expenses based on the company’s applicable interest rate and depreciation expense in order to properly document the economic event that was a capital lease.

Finally, a company had to depreciate the leased asset in a way that factored in salvage value and useful life. This is done using the straight line depreciation method.

Someone following the steps to book capital lease journal entries (now a finance lease entries) would have done as follows:

1. Made sure the lease was actually a capital lease (finance lease)
2. Booked a lease liability and right-of-use (ROU) asset by calculating the present value of all lease payments that was to be made over the determined period of the lease. The ROU asset was then further adjusted for any initial direct costs paid and incentives received.
3. Used future lease payments, such as monthly rents, to calculate the total straight-line monthly expense.
4. Separated the straight-line monthly expense into two categories: the imputed interest paid and the amount amortized against the principal value. 
5. The lease liability was then calculated each month as the present value of future payments.
6. Expensed the interest portion through a profit-and-loss account each month.
7. Reduced the ROU Asset by recording an amortization expense each month, which also flows through a profit and loss account.

What Were Capital Lease Journal Entries?

Capital lease journal entries for a capital lease were the fair value of all future lease payments, calculated as the present value of future lease payments in the lease contract. Capital lease journal entries included the initial recognition of the lease, along with finance lease interest, depreciation, and recording payments.

How Did You Record a Capital Lease on a Balance Sheet?

A properly recorded capital lease on a balance sheet should have had both the lease asset and the lease liability present on the balance sheet. The lease asset needed to be depreciated over the useful life of the lease period. Regardless of the timing of actual lease payments, the lease needed to be amortized and the interest recognized on the financial statements.

How Did Capital Leases Impact the Financial Statement?

For capital leases, lessees reported assets and liabilities on their balance sheet. Interest expense on the debt on the income statement was also required for reporting, and so were any depreciation expenses.

From a lessor perspective, the lease receivable had to be reported based on the present value of future lease payments, and the lessor should have reduced their assets by the amount of the asset that is leased. The income statement must have reflected any interest revenue on the lease.

Accounting for Capital Leases with Software

Worried about compliance with ever-changing lease accounting standards? Have questions? Need help calculating capital leases? Remember, they’re finance leases now! Contact us about our lease accounting software at LeaseCrunch and ditch the pesky spreadsheets today, exchanging them for white-glove customer service experience and software that reduces errors while increasing lease accounting efficiency.

FAQs

What was capital lease experience depreciation?

Capital lease depreciation was the amount an asset decreased in value over the course of a lease.

Capital lease vs. operating lease: what was the difference?

Whereas a capital lease imparted the characteristics of ownership on the lessee, an operating lease doesn’t convey any ownership rights of the asset to the lessee.

What was the difference between a capital lease and a normal lease?

The difference between a capital lease and a normal lease was the fact that a capital lease has the economic characteristics of asset ownership based on the ROU asset.