In this three-part article series, we’ll discuss the accounting treatment for various aspects of a leasing arrangement. This first part will cover capital lease accounting by the lessee (the party that takes possession of an asset in exchange for monthly lease payments).

1. Operating and capital lease classifications

We have previously discussed operating lease treatment - in short, rent expense is charged every month and nothing is capitalized on the balance sheet except for possible recognition of uneven payments throughout the lease term. In addition, we’ve previously mentioned four possible characteristics of capital leases (any of the following would result in a capital lease classification):

• Title passes to the lessee after the lease.
• There’s a bargain purchase at the end of the lease.
• The lease life is more than 75% of the asset’s useful life.
• The present value of the minimum lease payments is greater than 90% of the asset’s fair value.

Now we’ll take a brief look at how the lessee accounts for capital lease assets and periodic payments.

2. Initial recognition of leased asset and liability

Conceptually, there is little difference between (a) purchasing an asset and paying for it over time and (b) leasing the same asset for most or all of its useful life. U.S. GAAP acknowledges the potential for misleading off-balance sheet financing and therefore requires recognition of an asset and related liability for all capital leases.

The amount of the asset and liability equals the present value of the minimum lease payments plus the present value of the bargain purchase price or the present value of any guaranteed end-of-lease residual value. For a review of present value calculations and concepts, take a look at this tutorial about time value of money.

One item to consider is the interest rate for the lease. If the lessee knows the lessor’s implicit interest rate, that rate should be used for lease calculations. If not, the lessee should use its average borrowing rate. Let’s take a look at a quick example.

On January 1, 20X4, Friends Company leases a machine for 10 years. The lease requires annual payments of $10,000 every December 31. Friends Company knows that the interest rate implicit in the lease contract is 8%. The time value factor for an ordinary annuity at 8% for 10 periods is 6.71.

The asset and liability will be recorded by multiplying the annual lease payment by the present value factor. On January 1, 20X4, Friends will record the following journal entry:

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