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Capital Lease in Accounting: Definition, Requirements & Example

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  • 0:03 What's a Capital Lease?
  • 1:27 What's the Accounting…
  • 4:17 Putting It All Together
  • 4:48 Why Choose a Capital Lease?
  • 5:25 Lesson Summary
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Lesson Transcript
Instructor: Tiffany Crosby
In this lesson, we'll discuss the nature of capital leases. We'll look at what it means to 'own' an asset from an accounting standpoint so that we can understand why the accounting for capital leases differs from the accounting for operating leases. We'll then look at this accounting and some of its complexities.

What's a Capital Lease?

A capital lease is a lease which gives you all the rights associated with ownership, even as you continue to make lease payments. Suppose you were flipping through magazines and spotted your ideal motorcycle. It had everything you ever wanted, but there is a problem: you don't have the cash required to purchase it and you don't have the credit necessary to borrow money to buy it. So you contact the owner and see if the owner is willing to finance it for you. The owner says, 'Sure, I'll lease it to you.' You're not quite sure what that means, so you Google it.

You find out that a lease gives you the right to use the property as long as you make the lease payments. You're familiar with the concept of leasing as it relates to apartments, so that makes you feel a little better. But there's still a problem: you don't want to return the motorcycle. You don't want to give it back at the end of the lease. Essentially, you want to lease to own.

Businesses that have this problem may decide to enter into a capital lease. A capital lease is a financing scheme. The business gets to use the asset as if it owns it. As the owner, the company is fully responsible for any maintenance and repairs. The company is also responsible for any damage to the asset or any losses that it causes. The company records it on its own books and records. However, the business make payments every month based on the terms of the lease contract.

What's the Accounting Difference?

Accounting for capital leases is very different than accounting for operating leases. Let's look at each of these differences and the challenges that they create.

1. What's the Fair Value Today?

Because you're considered the owner of the leased asset, you must record the asset on your balance sheet. This represents the first challenge. In order to record it, you have to determine its fair value today. Since you're not paying for it all at one time, this is more difficult to calculate.

If the person received that money today, they could invest it at the current interest rate. In one year, they would receive the money invested plus the interest it earned. Since they delay receipt of the money into the future, we somehow have to figure out what all those payments that you make in the future are worth today. This is called present value.

For example:

Payment received 1 year from now: $1,000

Current interest rate: 6%

Present value (what it's worth today): $943.40

Said another way, if you invest $943.40 today and earn 6% interest, one year from now, you will receive $1,000. We would have to do this same calculation for each year of the lease.

Payment received 2 years from now: $1,000

Current interest rate: 6%

Present value (what it's worth today): $890

Once we had the amounts for each year, we would add them up to determine the fair value today. Fortunately, we have present value calculators and tables that can perform these calculations as long as we know how to use them. Once you know it's fair value, you now have to determine interest expense.

2. What's My Interest Expense?

Every lease payment that you make is comprised of two parts:

  1. Payment for the asset (i.e., principal)
  2. Interest expense

You have to separate the payment into those two pieces and record them separately. Once you have that separate, you still have one more question to answer before you can fully account for a capital lease.

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