Question

Outline the accounting procedures involved in applying the capital lease method by a lessee.

Short answer

An asset is purchased under the capital lease method on installment.

Step-by-step solution

Meaning of Capital Lease

The transfer of ownership rights from one party to another at the completion of a lease periodis termed a capital lease. A lessee might benefit from capital leasing by purchasing an asset at a lower cost than the market value.

Explaining the accounting procedures involved in applying the capital lease method by a lessee.

A lessee treats lease transactions as though an asset is being purchased on an installment basis under the capital-lease method—a financial transaction in which an asset is acquired and liability is generated. In a lessee's balance sheet, an asset and liability are equal to the lower of:

1. The present value of the minimum lease payments (excluding executory expenses) throughout the lease period, or
2. The fair value of the leased asset at the lease's beginning.

Unless a lessor's implicit rate is lower and a lessee is aware of it, the present value of the lease payments is determined using the lessee's incremental borrowing rate. Each lease payment is allocated between a decrease of the lease obligation and interest cost using the effective interest technique.

If a lease transfers ownership or includes a bargain purchase option, the asset depreciates in accordance with the lessee's standard depreciation strategy for owned assets, taking into account the item's economic life and salvage value. The leased asset is amortized over the lease period if the lease does not transfer ownership or contain a bargain purchase option.