3. Asset depreciation

According to U.S. GAAP, companies should depreciate an asset under a capital lease in roughly the same manner as a purchased asset. The only difference is that the asset will be depreciated over the life of the lease instead of the asset’s useful life if the asset must be returned to the lessor at the end of the contract term. If title passes to the lessee or if there’s a bargain purchase option, the asset’s useful life will be used instead.

Let’s assume that the machine described earlier has a useful life of 12 years. However, because the title to the asset will not transfer to Friends Company, the asset will be depreciated over the life of the lease (i.e., 10 years instead of 12 years). If the company uses straight-line depreciation, the following journal entry will be recorded every year. By the end of the lease term, the asset will be fully depreciated.

4. Liability accounting

At the same time the asset is being depreciated, the liability will be reduced every time Friends Company makes a payment. Part of the payment, however, will be interest. We need to use the effective interest method to allocate the payments between interest cost and reduction of the original liability. The carrying amount of the liability at the beginning of the year ($67,100) is multiplied by the interest rate (8%) to determine how much of the lease payment is allocated to interest expense ($5,368 = $67,000 x 8%). The rest goes toward reducing the liability. On December 31, 20X4, the following journal entry will be made:

Note that the liability on the balance sheet is now $62,468 ($67,100 - $4,632), so next year’s interest expense will be lower. At the end of the lease term, then, the liability will be paid off and the asset will be depreciated.

In our next article, we’ll discuss how the lessor accounts for a capital lease.

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