Capital Leases and Operating Leases

A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.

Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany ownership of property. A lease is a capital lease if, among other provisions, it (1) transfers ownership of the leased property to the lessee at the end of the lease term or (2) contains a bargain purchase option that permits the lessee to buy the property at a price significantly below fair market value at the end of the lease term.

A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase made on an installment plan. Thus, the lessee in a capital lease must record the leased property as an asset and the lease obligation as a liability. Because a capital lease is an asset, the lessee depreciates the leased property over its useful life. The lessee records part of each lease payment as interest expense and the balance as a payment on the lease liability.

The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text.

Operating leases A lease that does not qualify as a capital lease is an operating lease. A one-year lease on an apartment and a week’s rental of an automobile are examples of operating leases. Such leases make no attempt to transfer any of the rewards and risks of ownership to the lessee. As a result, there may be no recordable transaction when a lease is signed.

In some situations, the lease may call for an immediate cash payment that must be recorded. Assume that a business signed a lease requiring the immediate payment of the annual rent of $15,000 for each of the first and fifth years of a five-year lease. The lessee would record the payment as follows:

Prepaid Rent 15,000  
Leasehold 15,000  
Cash   30,000
To record first and fifth years’ rent on a five-year lease.    

Since the Leasehold account is actually a long-term prepaid rent account for the fifth year’s annual rent, it is an intangible asset until the beginning of the fifth year. Then the Leasehold account becomes a current asset and may be transferred into a Prepaid Rent account. Accounting for the balance in the Leasehold account depends on the terms of the lease. In the previous example, the firm would charge the $15,000 in the Leasehold account to expense over the fifth year only. It would charge the balance in Prepaid Rent to expense in the first year. Thus, assuming the lease year and fiscal year coincide, the entry for the first year is:

Rent Expense 15,000  
Prepaid Rent   15,000
To record rent expense.    

The entry in the fifth year is:

Rent Expense (-SE) 15,000  
Leasehold (-A)   15,000
To record rent expense.    

The accounting for the second, third, and fourth years would be the same as for the first year. The lessee records the rent in Prepaid Rent when paid in advance for the year and then expenses it. As stated above, the lessee may transfer the amount in the Leasehold account to Prepaid Rent at the beginning of the fifth year by debiting Prepaid Rent and crediting Leasehold. If this entry was made, the previous entry would have credited Prepaid Rent.

In some cases, when a lease is signed, the lump-sum payment does not cover a specific year’s rent. The lessee debits this payment to the Leasehold account and amortizes it over the life of the lease. The straight-line method is required unless another method can be shown to be superior. Assume the $15,000 rent for the fifth year in the example was, instead, a lump-sum payment on the lease in addition to the annual rent payments. An annual adjusting entry to amortize the $15,000 over five years would read:

Rent Expense 3,000  
Leasehold   3,000
To amortize leasehold.    

In this example, the annual rental expense is  $18,000:  $15,000 annual cash rent plus $3,000 amortization of leasehold ($15,000/5).

The lessee may base periodic rent on current-year sales or usage rather than being a constant amount. For example, if a lease called for rent equal to 5% of current-year sales and sales were $400,000, the rent would be $20,000 ($400,000 x 5%). The rent would either be paid or an adjusting entry would be made at the end of the year.