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Capital Lease Agreement Accounting: What You Need to Know

A capital lease agreement is a type of lease agreement where the lessee, or the party leasing the asset, assumes most of the risks and benefits associated with the asset being leased. That is, the lessee is essentially buying the asset and financing it through lease payments. Because the lessee is assuming most of the risks and benefits, capital lease agreements are treated as a form of debt in accounting and must be recorded accordingly.

So, what does this mean for accounting? When a capital lease agreement is made, the lessee must record the asset being leased on its balance sheet as a capital asset and record a corresponding liability for the lease payments. The amount recorded for the asset will be the present value of the lease payments expected to be made over the life of the lease. The interest rate used in calculating the present value of lease payments is typically the lessee’s incremental borrowing rate, which is the rate the lessee would have to pay to finance the lease in the absence of the lessor.

Additionally, the lease payment must be split between principal and interest portions. The interest portion is recognized as an expense in the income statement and the principal portion is used to reduce the liability on the balance sheet. The asset recorded on the balance sheet is then depreciated over the useful life of the asset, and the depreciation expense is recognized in the income statement.

It’s important to note that not all lease agreements are considered capital leases. Operating leases, for example, are a type of lease where the lessor retains most of the risks and benefits associated with the asset being leased, and the lessee records lease payments as an expense in the income statement. This distinction is important because it affects how the lease agreement is recorded and affects a company’s financial ratios and metrics.

In conclusion, capital lease agreement accounting involves recording the leased asset and corresponding liability on the balance sheet, splitting lease payments between principal and interest portions, and recognizing depreciation expense over the useful life of the asset. Understanding how to properly account for capital lease agreements is important for accurate financial reporting and decision making.