Capital leases, also known as finance leases, are long-term lease agreements where the lessee effectively assumes the risks and rewards of ownership of the leased asset. In accounting, capital leases require the lessee to record both an asset and a liability on their balance sheet. Below are examples of journal entries related to a capital lease.
1. Recording the Capital Lease at Inception
When a capital lease is initiated, the lessee records the leased asset and a corresponding liability at the present value of the lease payments.
Example: Recording the Initial Lease
Assume your business enters into a capital lease for equipment on January 1, 2024. The present value of the lease payments is $50,000. The lease has an interest rate of 5%.
Journal Entry on January 1, 2024:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 01-01-2024 | Leased Equipment | 50,000 | |
| 01-01-2024 | To Capital Lease Liability | 50,000 |
Explanation:
- Leased Equipment will debited to recognize the asset under the capital lease.
- Capital Lease Liability will credited to recognize the obligation to make lease payments.
2. Recording Lease Payments
Lease payments typically consist of both an interest portion and a principal portion. The interest portion is recorded as an expense, while the principal portion reduces the lease liability.
Example: Recording the First Lease Payment
Assume the annual lease payment is $11,000, with $2,500 representing interest for the first year.
Journal Entry on December 31, 2024:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2024 | Interest Expense | 2,500 | |
| 12-31-2024 | Capital Lease Liability | 8,500 | |
| 12-31-2024 | To Bank | 11,000 |
Explanation:
- Interest Expense will debited to record the interest cost of the lease.
- Capital Lease Liability will debited to reduce the outstanding lease obligation.
- Bank will credited to account for the lease payment made.
3. Depreciating the Leased Asset
Since the leased asset is capitalized, it must be depreciated over its useful life. The depreciation method used is usually consistent with the method used for similar assets owned by the lessee.
Example: Recording Depreciation
Assume the leased equipment has a useful life of 10 years, and your business uses straight-line depreciation.
Journal Entry for Annual Depreciation on December 31, 2024:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2024 | Depreciation Expense | 5,000 | |
| 12-31-2024 | To Accumulated Depreciation – Leased Equipment | 5,000 |
Explanation:
- Depreciation Expense will debited to recognize the expense associated with the use of the leased equipment.
- Accumulated Depreciation – Leased Equipment will credited to reflect the depreciation accumulated over the year.
4. Adjusting Lease Liability and Interest
As lease payments continue, the liability decreases, and the interest expense reduces in each subsequent period.
Example: Recording the Second Lease Payment
Assume the next lease payment is due on December 31, 2025, and the interest portion for this period is $2,125.
Journal Entry on December 31, 2025:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2025 | Interest Expense | 2,125 | |
| 12-31-2025 | Capital Lease Liability | 8,875 | |
| 12-31-2025 | To Bank | 11,000 |
Explanation:
- Interest Expense will debited to account for the interest incurred during the year.
- Capital Lease Liability will debited to reduce the outstanding lease liability.
- Bank will credited to reflect the lease payment made.
5. Recording the Final Lease Payment and Ownership Transfer
At the end of the lease term, if the lease agreement includes a bargain purchase option or the title transfers to the lessee, the final payment would typically complete the payoff of the lease liability, and the asset would remain on the balance sheet.
Example: Final Lease Payment
Assume the final lease payment is made on December 31, 2028, and the remaining lease liability is $8,875 with $375 as interest.
Journal Entry on December 31, 2028:
| Date | Account Title | Debit ($) | Credit ($) |
|---|---|---|---|
| 12-31-2028 | Interest Expense | 375 | |
| 12-31-2028 | Capital Lease Liability | 8,500 | |
| 12-31-2028 | To Bank | 8,875 |
Explanation:
- Interest Expense will debited to recognize the final interest payment.
- Capital Lease Liability will debited to eliminate the remaining lease liability.
- Bank will credited to reflect the payment made.
These entries ensure that the capital lease is accurately reflected in the financial statements, showing both the asset and liability, and accounting for the expenses and depreciation over time.