A capital lease, also known as a finance lease, is a non cancelable lease which is treated as the purchase of an asset using a loan. Under a capital lease, the business records both the leased equipment as an asset and the lease obligation as a long-term liability.
What Is a Capital Lease?
A lease is treated as a capital lease if it meets any one of the following conditions:
- Ownership transfers to the lessee at the end of the lease
- The lease contains a bargain purchase option
- The lease term covers most of the asset’s useful life
- The present value of lease payments is a major portion of the asset’s fair value
Capital leases look and act like loans in accounting.
Example 1: Equipment Taken on Capital Lease
A contractor takes heavy equipment on a capital lease.
- Present value of lease payments: $150,000
Accounting Treatment at the Start of the Lease
At the beginning of the lease:
- Equipment is recorded as a fixed asset
- Lease payable is recorded as a long-term liability
Journal Entry – Capital Lease Recorded
Leased Equipment A/c Dr. 150,000
To Capital Lease Payable A/c 150,000
(Being equipment recorded under capital lease at present value)
Effect on Balance Sheet (At Lease Start)
| Account | Effect | Amount ($) |
|---|---|---|
| Leased Equipment | Increase | 150,000 |
| Capital Lease Payable | Increase | 150,000 |
Lease Payments on a Capital Lease
Each capital lease payment has two parts:
- Principal portion – reduces lease liability
- Interest portion – recorded as interest expense
Only the interest portion affects profit.
Example 2: First Capital Lease Payment
Total lease payment made: $3,500
- Principal repayment: $2,600
- Interest expense: $900
Accounting Impact of Lease Payment
Balance Sheet
- Cash decreases by $3,500
- Capital lease payable decreases by $2,600
Income Statement
- Interest expense of $900
- Profit decreases by $900
Journal Entry – Capital Lease Payment
Capital Lease Payable A/c Dr. 2,600
Interest Expense A/c Dr. 900
To Cash / Bank A/c 3,500
(Being capital lease payment made including principal and interest)
Important Accounting Points
- A capital lease creates a fixed asset
- A lease obligation is a long-term liability
- Principal payment reduces liability
- Interest is an expense
- Principal repayment does not affect profit
- Depreciation is charged on leased equipment
Capital Lease vs Operating Lease Comparison
| Particulars | Capital Lease | Operating Lease |
|---|---|---|
| Asset Recorded | Yes | No |
| Liability Recorded | Yes | No (except payable) |
| Interest Expense | Yes | No |
| Depreciation | Yes | No |
| Treated Like Loan | Yes | No |
Conclusion
Accounting for leased equipment under a capital lease is similar to accounting for equipment purchased with a loan. Assets and liabilities are recorded at the start, and each payment is split between principal and interest to ensure accurate financial reporting.
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