Edited by Maluniu, Leona, Roxane, BR and 5 others
A lease is an agreement between a lessor and a lessee by which the lessor will rent an asset to the lessee for a specified period of
Edited by Maluniu, Leona, Roxane, BR and 5 others
A lease is an agreement between a lessor and a lessee by which the lessor will rent an asset to the lessee for a specified period of time, with regular payments due to the lessor for use of the asset. Leases are common in the business environment for large pieces of equipment and buildings. There are 2 types of leases: operating leases and capital leases. The accounting treatments employed depend on the type of lease at hand, and knowing how to account for a lease depends on being able to determine which type of lease you are working with.
Method 1 of 3: Categorize the Lease
1Familiarize yourself with the differences between capital leases and operating leases. Knowing how to account for a lease begins with categorizing the lease properly.
- An operating lease occurs when the lease represents a true rental agreement. Most of the risks and rewards associated with ownership of the leased asset remain with the lessor, and the lessee does not have any way to purchase the asset. An operating lease represents an expense to the lessee and revenue to the lessor.
- A capital lease represents a material transfer of ownership. This means that the lessee has essentially purchased the asset from the lessor, and the rent payments are more accurately classified as a financing plan. A lease must be accounted for as a capital lease if any 1 of the following 4 conditions are true: the lessee will gain title of the asset at the end of the lease; the lessee will be able to purchase the asset for a price below market value at the end of the lease; the term (length of time) of the lease accounts for 75 percent or more of the useful life of the asset; and the net present value of all the rent payments equals 90 percent of more of the asset's market value.
Method 2 of 3: Account for an Operating Lease
1Record the journal entries for the operating lease. Operating leases are simple: the lessor records a revenue, while the lessee records an expense. Consider a lease agreement by which ABC Corporation leases a dozen large printers to XYZ Company for 5 years in exchange for yearly rent payments of $1000.
- ABC Corporation (the lessor) will record an identical journal entry each year. They will debit Cash for $1000 and credit Rent Revenue for $1000. If the payment is made at the beginning of each year, they must instead debit Cash for $1000 while crediting Unearned Rent for $1000. At the year's end, the Unearned Rent account balance will be moved to Rent Revenue.
- XYZ Company (the lessee) will record the same journal entry each year. They will debit Rent Expense for $1000 and credit Cash for $1000. If they make payments at the beginning of the year, they will instead debit Prepaid Rent (an asset) for $1000, while crediting Cash for $1000. Prepaid Rent's balance is moved to Rent Expense at the year's end.
Method 3 of 3: Account for a Capital Lease
1Record the journal entries upon origination of the capital lease. Capital leases must be accounted for like a sale. Consider the lease agreement above, with the additional stipulation that XYZ Company shall receive title of the printers at the end of the lease.
- ABC Corporation records an entry in the general journal at the time the lease agreement originates. They debit Lease Receivable (an asset) for $5000-the total amount of the lease. They credit Printers (also an asset account) for $5000.
- XYZ Company also records a journal entry at the beginning of the lease. They debit Printers for $5000 and credit Lease Payable for $5000.
2Record the journal entries as each payment is made. Each year, a journal entry will be needed by both companies to recognize the rent payments.
- ABC Corporation will debit Cash for $1000 and credit Lease Receivable for $1000.
- XYZ Company will debit Lease Payable for $1000 and credit Cash for $1000.
- The examples above will work equally well when expressed in other currencies.
Things You'll Need
- Accounting software (optional)