Capital lease accounting journal entries is Machinery Account Debit and Lease Liability Account Credit, and second entry is Interest Expense Account Debit, Lease Liability Account Debit and Cash/Bank Account Credit. A capital lease, also known as finance lease, is a lease in which the lessee assumes some of the risks and benefits of ownership of the leased asset for accounting purposes, the leased asset is treated as if it were purchased.
Example Scenario
Let’s assume Company A enters into a capital lease for machinery on 01-01-2024. The lease agreement states that:
- The machinery has a fair value of ₹5,00,000.
- The lease term is 5 years.
- Annual lease payments are ₹1,20,000, made at the end of each year.
- The implicit interest rate is 10%.
Initial Recognition of the Capital Lease
At the inception of the lease, Company A will recognize the machinery as an asset and a corresponding lease liability.
Initial Journal Entry to Record the Lease Asset and Liability:
| Date | Account Title | Debit (INR) | Credit (INR) | Description |
|---|---|---|---|---|
| 01-01-2024 | Machinery | 5,00,000 | Recording the leased asset | |
| 01-01-2024 | To Lease Liability | 5,00,000 | Recording the lease liability |
Explanation:
- Machinery Account Will Debit: This records the leased asset at its fair value.
- To Lease Liability Account Will Credit: This records the obligation to make lease payments.
Annual Lease Payment and Interest
For each annual payment, part of the payment reduces the principal amount of the lease liability, and part of it is an interest expense.
First Annual Lease Payment on 31-12-2024:
| Date | Account Title | Debit (INR) | Credit (INR) | Description |
|---|---|---|---|---|
| 31-12-2024 | Interest Expense | 50,000 | Recording interest expense (10% of ₹5,00,000) | |
| 31-12-2024 | Lease Liability | 70,000 | Reducing the lease liability | |
| 31-12-2024 | To Cash/Bank | 1,20,000 | Payment of annual lease installment |
Explanation:
- Interest Expense Account Will Debit: Records the interest expense for the year.
- Lease Liability Account Will Debit: Reduces the principal portion of the lease liability.
- To Cash/Bank Account Will Credit: Records the cash payment made for the lease installment.
Subsequent Annual Payments
In subsequent years, the interest expense will decrease as the principal amount of the lease liability decreases.
Second Annual Lease Payment on 31-12-2025 (assuming the lease liability has reduced):
| Date | Account Title | Debit (INR) | Credit (INR) | Description |
|---|---|---|---|---|
| 31-12-2025 | Interest Expense | 43,000 | Recording interest expense on reduced liability | |
| 31-12-2025 | Lease Liability | 77,000 | Reducing the lease liability | |
| 31-12-2025 | To Cash/Bank | 1,20,000 | Payment of annual lease installment |
Depreciation of the Leased Asset
The machinery is also depreciated over its useful life. Assuming a straight-line depreciation method over 5 years:
Annual Depreciation Expense:
| Date | Account Title | Debit (INR) | Credit (INR) | Description |
|---|---|---|---|---|
| 31-12-2024 | Depreciation Expense | 1,00,000 | Recording annual depreciation | |
| 31-12-2024 | To Asset(Accumulated Depreciation) | 1,00,000 | Accumulating depreciation |
Explanation:
- Depreciation Expense Account Will Debit: Records the depreciation expense for the year.
- To Asset(Accumulated Depreciation) Account Will Credit: Records the accumulated depreciation on the leased asset.
Conclusion
Accounting for a capital lease involves recognizing the leased asset and the associated liability, making regular lease payments, accounting for interest expense, and depreciating over the asset’s useful life. This ensures accurate financial reporting and compliance with accounting standards.