Companies lease buildings and equipment to use in their business without incurring the expense of building the equipment themselves. These leases last several years and can be classified in two ways, as a capital lease or as an operating lease.
Capital Lease - Lessee
In a capital lease, the lessee records the leased property as an asset and the lease obligation as a liability in the company’s accounting records. To qualify as a capital lease, the lease must transfer ownership to the lessee, include a bargain purchase option, extend beyond 75 percent of the asset’s useful life or have a present value greater than or equal to 90 percent of the asset’s fair market value. At the initiation of the lease, the lessee records a debit to the Fixed Asset account and a credit to Lease Obligation. Throughout the life of the lease agreement, the lessee records depreciation expense by debiting Depreciation Expense and crediting Accumulated Depreciation. The company records every lease payment by debiting Lease Obligation and Interest Expense and crediting Cash.
Capital Lease - Lessor
The lessor treats a capital lease as a sale. When the lease agreement takes effect, the lessor debits Lease Receivable and credits Fixed Assets. Every time the company receives a payment, the company reduces the receivable owed by the lessee. The lessor records a debit to Cash and a credit to Lease Receivable.
Operating Lease - Lessee
An operating lease meets none of the criteria to be considered a capital lease. The lessee uses the asset through the duration of the lease and returns the asset to the lessor at completion of the lease. Each month, the lessee records a journal entry debiting Lease Expense and crediting Cash.
Operating Lease - Lessor
The lessor treats the operating lease as property rental. No journal entry is made to record the initiation of the lease. At the end of each period, the lessor records a journal entry debiting Cash and crediting Lease Revenue.