In a capital lease transaction, Lessee uses the lease as a source of financing. Lessor finances the transaction (provides the investment capital) through the leased asset. Lessee makes rent payments, which actually are installment payments. Therefore, over the life of the aircraft rented, the rental payments to Lessor constitute a payment of principal plus interest.
Asset and Liability Recorded
Under the capital lease method, Lessee treats the lease transaction as if it purchases the aircraft in a financing transaction. That is, Lessee acquires the aircraft and creates an obligation. Therefore, it records a capital lease as an asset and a liability at the lower of
(1) the present value of the minimum lease payments (excluding executory costs) or
(2) the fair value of the leased asset at the inception of the lease.
(2) the fair value of the leased asset at the inception of the lease.
The rationale for this approach is that companies should not record a leased asset for more than its fair value.
Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Lessee (criterion 1) or contains a bargain-purchase option (criterion 2), Lessee depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain purchase option, then Lessee depreciates it over the term of the lease. In this case, the aircraft reverts to Lessor after a certain period of time.
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Lessee (criterion 1) or contains a bargain-purchase option (criterion 2), Lessee depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain purchase option, then Lessee depreciates it over the term of the lease. In this case, the aircraft reverts to Lessor after a certain period of time.
Effective-Interest Method
Throughout the term of the lease, Lessee uses the effective-interest method to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. When applying the effective-interest method to capital leases, Lessee must use the same discount rate that determines the present value of the minimum lease
payments.
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Throughout the term of the lease, Lessee uses the effective-interest method to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. When applying the effective-interest method to capital leases, Lessee must use the same discount rate that determines the present value of the minimum lease
payments.
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Depreciation Concept
Although Lessee computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years’-digits, declining-balance, units of production, etc.
Although Lessee computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years’-digits, declining-balance, units of production, etc.
The FASB uses the term “amortization” more frequently than “depreciation” to recognize intangible leased property rights. We prefer “depreciation” to describe the writeoff of a tangible asset’s expired services.