A lease is a contract in which one party (lessor) agrees to transfer an asset to another party (lessee) in exchange for periodic payments or a secured long-term debt. With an operating lease, the lessor maintains ownership of the leased asset. In a capital lease, the lessee owns the asset when the lease is complete.
Accounting rules and Internal Revenue Service (IRS) guidelines do not allow depreciation of leased assets in the cases of operating leases. In a capital lease, a company or business owner may depreciate a leased capital asset with a straight-line method. Depreciation is an accounting convention that allows a firm to recover an asset's value over time. With a straight-line depreciation procedure, a corporate accountant records the same depreciation amount each year. For example, a company signs a capital lease agreement with a lessor, receiving equipment valued at $1 million. The firm's accounting chief reviews IRS guidelines and opts for a five-year depreciation term. The annual depreciation expense is $200,000 ($1 million divided by five). To record the depreciation, the accountant debits the depreciation expense account for $200,000 and credits the accumulated depreciation account for the same amount. At the end of the first year, the leased asset's value is $800,000 ($1 million minus $200,000).
The Modified Asset Cost Recovery System (MACRS) is also referred to as accelerated depreciation. With MACRS, a company records higher leased asset depreciation expenses in earlier years. MACRS may be financially advantageous if an individual or corporate taxpayer wants to lower fiscal liabilities. For example, a firm signs a capital lease agreement covering machinery valued at $100,000. The firm's controller believes a "50-30-20" MACRS depreciation plan is advantageous, given corporate profit forecasts for the next three years. At the end of the first year, the depreciation expense is $50,000 ($100,000 times 50 percent). Depreciation amounts for the second and third years are $30,000 ($100,000 times 30 percent) and $20,000 ($100,000 times 20 percent), respectively. To record the depreciation, the company's accountant debits the depreciation expense account for $50,000 and credits the accumulated depreciation account for the same amount. At the end of the first year, the leased asset's value is $50,000 ($100,000 minus $50,000).
Leased asset depreciation expense is a non-cash item. A company does not pay for depreciation expense, unlike other general and administrative expenses, such as materials, salaries, rent and interest. Yet, depreciation lowers corporate fiscal and accounting income. Capital lease depreciation expense is an income statement item. Accumulated depreciation is a balance sheet component.