Accounting for a Capital Lease

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Accounting for leases is a complicated topic. With recent changes, the IFRS has clarified how companies can distinguish a capital lease. This standard also guides on what the accounting treatment is.

What is a Capital Lease?

A capital lease, often referred to as a finance lease, is a lease agreement that allows a lessee to acquire and utilize an asset for an extended period, typically covering a substantial portion of the asset’s useful life. What sets a capital lease apart is its economic substance, as it resembles ownership in many ways. The lessee assumes responsibilities such as maintenance, insurance, and taxes, making it distinct from operating leases, which are more akin to rental agreements.

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In a capital lease, the ownership of the asset is often transferred to the lessee at the end of the lease term, often for a nominal price or a percentage of the asset’s fair market value, and it may include a bargain purchase option. This lease is accounted for as if the lessee has acquired the asset through a loan, appearing on the lessee’s balance sheet as both an asset and a corresponding liability for the present value of lease payments.

What is the accounting for a Capital Lease?

Under the new International Financial Reporting Standards (IFRS 16), the accounting treatment for finance leases, also known as capital leases, has undergone significant changes. IFRS 16, effective from January 1, 2019, brought forth a fundamental shift in how lessees account for these leases. Instead of distinguishing between operating and finance leases, the lessees recognize both on their balance sheets.

At the commencement of a finance lease, the lessee recognizes a right-of-use asset (ROU asset) and a corresponding lease liability, representing the present value of future lease payments. The ROU asset is measured at cost and subsequently depreciated, while the lease liability gets adjusted as payments are made and recognized as interest expense.

This shift aims to enhance transparency in financial reporting, offering a more accurate representation of a lessee’s obligations and financial position. Entities must adhere to these new IFRS accounting standards, ensuring compliance and transparency in financial reporting and providing stakeholders with a clearer view of their lease-related financial obligations.

What is the journal entry for a Capital Lease?

The journal entry for a capital lease under the new IFRS 16 standard requires the recognition of a right-of-use asset. When a company acquires a resource through a capital lease, it must recognize a liability for the present value of the future lease payments. On the other hand, it must also create a right-of-use asset. The journal entry is as follows.

Dr        ROU asset

Cr        Lease liability

The value for both of these comes from the lease amortization schedule, which calculates the present value of the future lease payments. Once the company recognizes the asset, it must depreciate it under the applicable accounting standard. The journal entry for it is as follows.

Dr Depreciation
Cr Accumulated depreciation

Similarly, the company must recognize an interest expense and decrease the liability for every lease payment made over time. The principal and interest figures may differ for every occurrence based on the lease amortization schedule. The journal entry to record a lease payment is as follows.

Dr Interest expense
Dr Lease liability
Cr Bank or cash

Conclusion

A capital lease is a lease agreement that lasts for over 12 months. The accounting for capital leases has changed due to IFRS 16. This standard requires companies to recognize a right-of-use asset when a company obtains a resource under a capital lease. For every fiscal period, the company must also record an interest expense and reduce the lease liability.

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