How to Account for a Lease Liability on a Cash Flow Statement

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Under Financial Accounting Standards Board rules, how you record your lease liability on your cash flow statement depends on the type of lease you own. There are two types of leases: Operating and capital leases. In the case of operating leases, the lessor retains the assets and liability of owning it on its balance sheet. Among capital leases, direct-financing and sales-type leases receive different accounting treatment on the financial statements because they allow you to enjoy the benefits of ownership such tax deduction for depreciation and interest expense associated with the lease.

Operating Leases

Create a general account for the leased asset. This creates a T account which records debits on the left and a credit on the right. A T-account is a visual aid used by accountants and accounting software programs to show a journal entry's effect on the general ledger accounts.

Debit the lease payment in the Rent expense account you created for the operating lease. Credit the same amount to the cash account. This appears as a cash outflow in the cash flow statement. Because the lease is an operating lease, it appears as part of your operating expense.

Include your lease payment as part of your operating expenses in the cash flow statement. Under an operating lease, you rent the assets. The FASB requires that you record the rental expense under operating activities. The lease payments should be included as part of working capital, which is the difference between your short-term assets and short-term liabilities.

Capital Lease

Create a general ledger account for the capital lease asset. For example, if you leased a computer server, create an account called, "Computer Server" in the general ledger account. This automatically establishes a T account for the computer asset. If you lease a computer server for $4,000, debit $4,000 to the "Computer Server" T-account and credit the same amount under Capital Lease Obligation.

Record the annual lease payments. Because it is a capital lease, you must record the lease payments that include interest expense and your capital lease obligation separately. A capital lease is a commitment to the lessor similar to borrower financing, so it should be treated as a debt that includes interest expense. For example, given an effective borrowing rate of 8 percent and annual lease payments of $1,240, the interest expense is $320 in year 1. The capital lease obligation is the difference or $920 ($1,240 - $320). Debit interest expense and capital lease obligation for $320 and $920, respectively. Credit cash for $1,240.

Record the two components of the lease payment under cash flow from operating activities. List $320 of interest expense and $920 in capital lease obligation. Because this is a capital lease, you also record depreciation expense. For example, if the computer server has a five-year life, using straight-line depreciation, the annual depreciation expense is $800. Since depreciation is a non-cash expense, add $800 back to net income when you list cash flow from operating activities.

Tips & Warnings

  • Accounting for operating leases is straightforward because the rental expense doesn't change. However, under a capital lease, the debits and credit change from year to year. Continuing with the same example, in year 2, the annual lease payment remains the same but the interest expense declines to $246.40 (($4,000 - $920 capital lease obligation in year 1) x 8 percent). The lease obligation in year 2 decreases to $993.60 ($1,240 - $246.40). Calculate the interest expense and capital lease obligations in the same way for years 3 through 5 until both reduce to zero.

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