Impact of Capital Leases on Financial Statements

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  • 0:03 Capital Lease
  • 0:55 Leasing a Sports Car
  • 4:35 Lesson Summary
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Lesson Transcript
Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you'll learn how to record the journal entries for a capital lease. You'll also learn what impact a capital lease has on the balance sheet, income statement, and cash flow statement for a lessee.

Capital Lease

You've probably heard of the terms operating lease and capital lease before. What's the difference between the two? For an operating lease, the rights and responsibilities of ownership stay with the lessor (the one who owns the asset and leases it out). The lessee (the one who uses the asset) doesn't record the value of the asset on their balance sheet. Instead, they make periodic payments for use of the asset.

A capital lease is similar, in that the lessee makes periodic payments, but they also get ownership of the asset. They put the asset on their books. Let's walk through an example where you lease a sports car for car's entire useful life. We'll walk through how accountants record the transaction, and we'll describe the impact each accounting journal entry has on the balance sheet, income statement, and cash flow statement.

From 0 mph to 60 mph, here we go…

Leasing a Sports Car

Imagine you've leased your dream sports car. The terms of the lease are a bit unusual. Instead of monthly payments, you need to pay five annual payments of $5,000 beginning January 1, 2018, on the date of the lease's inception, and continuing every January 1 until the last payment on January 1, 2022. The car company has an expected rate of return of 10% during the lease. This means as you pay the lease they expect to earn 10% on the sports car's cost each year. This will come in handy when we calculate the first payment.

Once the lease payments are complete, you own the car! During this time, and thereafter, you retain the rights and responsibilities of ownership. Because of this arrangement, you put the value of the car on your personal balance sheet. And, the value of the car is taken off the car company's balance sheet. Your journal entries would look like this:

Dr. Leased Car $25,000
Cr. Lease Payable $25,000

From this we can tell the impact on the balance sheet: Your assets have increased by $25,000, the leased car amount, and your liabilities have also increased by $25,000, the lease payable. No impact can be noted on the income statement because no time has elapsed. And, at lease inception, there is no transfer of cash, so therefore the cash flow statement remains unchanged.

Now, let's go to the payment dates. January 1, 2019 is the date of our first payment. You can think of each payment like a mortgage payment. The payment is a mix of interest and principal. At the start of the lease, interest expense represents a large percentage of the payment amount. As the lease goes on and the book value of the lease payable is decreased, interest expense decreases as a proportion of the lease payment and principal reduction increases as a proportion.

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