Financial Statement Presentation for Capital Leases

Financial statement presentation for operating leases is a snap. Unless you have an event such as a finder’s fee, no part of the transaction is capitalized. You treat the entire extravaganza as a straight-out expense.

Capital leases are a bit more complicated. But don’t worry — by the time you get to the end of this section, you’ll be working through the lessee capital lease accounting like a pro! In this section, I show you how to journalize a capital lease transaction and how to reflect a capital lease on the balance sheet and income statement.

For the lessee, capital leases affect both the asset and liability sections of the balance sheet. The lessee also has to allocate the liability between current and long-term liabilities.

This situation is a lot easier to work through if you have a fleshed-out example to follow, so here’s one now:

On October 1, 2012, Michael, Inc., leases a machine from a captive leasing company for a monthly rental of $50,000. The term of the lease is 12 years, and the company reckons that the useful life of the machine is five years. There’s no salvage value and no maintenance payments. Michael plans to use the straight-line method of depreciation.

Borrowing money to pay for this type of transaction would cost Michael 12 percent per year. Michael makes the lease payments at the beginning rather than the end of each month.

Keep in mind the following facts:

  • To figure the asset and liability, you need to check out the present value of an annuity of 1 table to get the factor. The factor of 76.899 is at the intersection of 144 periods (12 years x 12 months in each year) and 1 percent (12 percent / 12 months in a year).

    Remember, the lease payment is monthly, not yearly. The asset and liability amounts are 3,844,950 (the monthly lease payment of $50,000 x 76.899).

  • The depreciation amount per month is $26,701 ($3,844,950 lease liability / 144 periods).

  • Interest expense per month is figured on the unpaid balance at the end of the month multiplied by 1 percent. Book this at the end of the month. For the first month, the interest expense is $37,950 ($3,794,950 [$3,844,950 lease liability – $50,000, the payment made on October 1] x .01)

First, tackle the journal entries shown in the figure. The journal entry is a three-part process that involves booking the acquisition of the leased asset, divvying up the lease payment between principal and interest, and recording depreciation for the leased asset.

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Remember that these are the journal entries for the lessee, not the lessor. Looking at the accounts you affect in the journal entries, some are balance sheet accounts and some are income statement accounts. Now do an account/financial statement round-up.

Account/Financial Statement Round-Up
Balance Sheet Income Statement
Lease Equipment — Fixed Asset Interest Expense
Lease Liability — Liability (current and long-term) Depreciation Expense
Cash — Current Asset
Interest Payable — Current Liability
Accumulated Depreciation — Contra-asset Account

Now that you have your journal entry accounts classified by financial statement, it’s time to figure out the current versus long-term amounts for the lease liability presentation on the October 31, 2012, balance sheet.

This fairly simple intermediate accounting textbook procedure is easy to understand when checking out the lease amortization schedule. The lease amortization schedule shows how the amount of the lease payment is divvied up between interest and reduction of lease liability.

Here is a partial lease amortization schedule for Michael, Inc. This schedule reflects three payments Michael made at the beginning of October, November, and December and the accrual of three months’ worth of interest from October 1, 2012, through December 31, 2012.

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Following is a partial balance sheet reflecting the lease transaction. Pull the numbers for the liabilities from the lease amortization schedule. Figure accumulated depreciation by multiplying the monthly amount of $26,701 by three months (October, November, and December). The income statement, which isn’t shown, is affected by reducing net income by both the interest and depreciation expense.

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