ASC 840 Leases (Legacy Standard): Capital Lease Transaction Explained with Journal Entries

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The ASC 840 Leases, a legacy accounting standard, provided guidance for lease accounting prior to the adoption of ASC 842. Under ASC 840, leases were classified as either operating or capital leases, with different accounting treatment for each category. In this article, we will focus on capital leases under ASC 840, explaining the criteria for classification, the accounting treatment, and providing examples of journal entries for a capital lease transaction.

 

Capital Lease Criteria under ASC 840

A lease was classified as a capital lease under ASC 840 if it met one or more of the following criteria:
 

  1. Transfer of ownership: The lease agreement transfers ownership of the leased asset to the lessee by the end of the lease term.
     

  2. Bargain purchase option: The lease agreement provides the lessee with an option to purchase the leased asset at a bargain price at the end of the lease term.
     

  3. Lease term: The lease term is equal to 75% or more of the estimated economic life of the leased asset.
     

  4. Present value test: The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased asset.

 

Capital Lease Accounting Treatment

Under ASC 840, a capital lease required the lessee to record the leased asset and a lease liability on their balance sheet. The leased asset was depreciated over the lease term, while the lease liability was reduced by the principal portion of the lease payments. The lessee also recognized interest expense on the lease liability.

 

Capital Lease Journal Entries

To illustrate the capital lease accounting treatment, consider the following example:

A company (lessee) enters into a 5-year capital lease for equipment with a fair value of $100,000. The annual lease payments are $25,000, and the implicit interest rate is 5%. The present value of the minimum lease payments is $98,500, meeting the present value test for a capital lease.
 

Journal entries for the lessee under ASC 840 would include:
 

  1. At the inception of the lease:

            Dr. Leased Equipment (Asset) $98,500

            Cr. Lease Liability $98,500

 

(To record the leased equipment and lease liability at the present value of the minimum lease payments)

 

  1. At the end of each year, when making the lease payment:

            Dr. Lease Liability (Principal) $18,025

            Dr. Interest Expense $6,975

            Cr. Cash $25,000

 

(To record the lease payment, reducing the lease liability by the principal portion and recognizing interest expense)

 

  1. At the end of each year, to record depreciation:

            Dr. Depreciation Expense $19,700

            Cr. Accumulated Depreciation $19,700

 

(To record annual depreciation on the leased equipment over the 5-year lease term)
 

Capital lease accounting under ASC 840 requires lessees to recognize the leased asset and lease liability on their balance sheet, with depreciation and interest expense recognized over the lease term. Although ASC 842 has superseded ASC 840, understanding the legacy standard is still important, as it provides historical context and insight into the evolution of lease accounting.