To book a capital lease — now called a finance lease under ASC 842 — you record a Right-of-Use (ROU) asset and a Lease Liability on the commencement date, each measured at the present value of the lease payments, and then in every period after that you split the payment between interest expense and principal, and separately amortize the ROU asset. That is the whole mechanic. The rest is getting the inputs right.
Confirm the Lease Is a Finance Lease First
A lease is a finance lease if it meets any one of five criteria at commencement:
- Ownership transfers to you by the end of the lease term.
- The lease includes a purchase option you are reasonably certain to exercise.
- The lease term covers the major part of the asset’s remaining economic life.
- The present value of lease payments (plus any residual value you guarantee) equals or exceeds substantially all of the asset’s fair value.
- The asset is so specialized it has no alternative use to the lessor at the end of the lease.
The lease-term test is skipped if the lease begins at or near the end of the asset’s economic life; implementation guidance treats “at or near” as the last 25 percent of total economic life.1Financial Accounting Standards Board. ASU 2016-02 Leases Topic 842 Many companies still apply the familiar 75 percent (lease term) and 90 percent (present value) tests from the old ASC 840 rules as a “reasonable approach” under 842’s principles-based language, but if you adopt them as policy you have to follow them consistently in both directions.
If none of the five criteria are met, it’s an operating lease. You still put an ROU asset and a lease liability on the balance sheet, but the expense pattern is different, and that is a separate topic from booking a capital lease.
Measure the Lease Liability
The lease liability is the present value of the payments you expect to make over the lease term. “Lease payments” for this calculation includes:
- Fixed payments, minus any lease incentives receivable.
- In-substance fixed payments — variable in form but effectively unavoidable.
- Variable payments tied to an index or rate (such as CPI), measured using the index at commencement.
- The amount you’ll probably owe under a residual value guarantee (not the full guaranteed amount).
- The strike price of a purchase option you’re reasonably certain to exercise.
- Any termination penalty, if the lease term reflects early termination.
Variable payments that depend on performance or usage (a percentage of sales, per-mile charges) are excluded and expensed as incurred.1Financial Accounting Standards Board. ASU 2016-02 Leases Topic 842
Picking the Discount Rate
Discount those payments at the rate implicit in the lease if you can determine it. Most lessees can’t, because it depends on the lessor’s expected residual value and initial direct costs. When the implicit rate isn’t determinable, use your incremental borrowing rate: the rate you’d pay to borrow a similar amount, secured, over a comparable term, in a similar economic environment. Private companies may elect to use a risk-free rate (a Treasury rate of comparable term) for all leases. That election is simpler but produces a larger liability, since risk-free rates are lower than borrowing rates.
Measure the Right-of-Use Asset
Start the ROU asset at the same amount as the lease liability. Then:
- Add initial direct costs — commissions, certain legal fees, document preparation charges.
- Add any lease payments you made to the lessor before the commencement date.
- Subtract any lease incentives the lessor gave you (signing bonus, tenant improvement allowance, and similar).
In a straightforward lease with no prepayments, no direct costs, and no incentives, the ROU asset equals the lease liability on day one.
The Day-One Journal Entry
On the commencement date, post:
- Debit Right-of-Use Asset, for the full ROU value.
- Credit Lease Liability, for the present value of the payments.
If you paid initial direct costs in cash, credit Cash for that amount as well; the debit is already in the higher ROU figure. If a lease payment is due at commencement rather than in arrears, that first payment isn’t a future obligation, so record it separately: debit Lease Liability, credit Cash. After these entries, the asset you’ll use and the obligation you owe are both on the balance sheet.
Booking Interest and Amortization Each Period
This is where finance lease accounting parts ways with operating leases. Each period you record two expenses, not one: interest on the liability, and amortization of the ROU asset.
Interest Expense and Principal Reduction
Split each payment using the effective interest method. Interest for the period equals the outstanding lease liability balance multiplied by the discount rate from commencement. The rest of the cash payment reduces the principal.
A quick example. Outstanding liability is $27,232, discount rate is 5 percent. Interest for the period is $1,361.60. If the scheduled payment is $10,000, the other $8,638.40 reduces principal, leaving a balance of $18,593.60 that becomes the base for next period’s interest calculation. Interest is front-loaded: higher early in the lease, lower later.
The journal entry each period:
- Debit Interest Expense (the calculated interest portion).
- Debit Lease Liability (the principal portion).
- Credit Cash (the total payment).
Build a full amortization schedule at commencement, mapping every payment period with its interest, principal, and remaining liability balance. Doing this before you post any subsequent entries is the single most effective way to avoid errors later.
Amortization of the ROU Asset
The period over which you amortize depends on which classification criterion the lease met:
- If ownership transfers or you’re reasonably certain to exercise a purchase option (criteria 1 or 2): amortize over the asset’s full useful life, because you’ll own it at the end.
- For the other three criteria: amortize over the shorter of the lease term or the asset’s useful life, since the asset reverts to the lessor.
Most companies use straight-line amortization. The entry each period:
- Debit Amortization Expense.
- Credit Right-of-Use Asset (or Accumulated Amortization as a contra-asset).
Combined with front-loaded interest, total expense is higher in the early years and declines over the life of the lease. Total expense across the full term equals total cash paid, but the timing differs from an operating lease.
When You Don’t Have to Book It
ASC 842 provides a short-term lease exemption. If the lease term is 12 months or less at commencement and there’s no purchase option you’re reasonably certain to exercise, you can elect not to recognize an ROU asset or liability and instead expense the payments straight-line. The election is made by class of underlying asset, so you need a consistent policy for each category.
ASC 842 has no formal low-value-asset exemption like IFRS 16, but the Basis for Conclusions acknowledges that companies can set reasonable capitalization thresholds below which they don’t recognize lease assets and liabilities, so long as the aggregate excluded amount doesn’t become material.
When You Have to Remeasure
Leases change: term extensions, added space, payment reductions, early termination. If a modification grants you an additional right of use and increases payments proportionally to the standalone price of that addition, treat it as a separate new lease and leave the original alone.
Every other modification requires remeasurement. You reassess whether the contract is still a lease, reclassify if the criteria now push it into a different category, recalculate the liability using a revised discount rate as of the modification date, and adjust the ROU asset. For a finance lease where scope decreases, any reduction in the ROU asset that exceeds the proportional reduction in the liability is recognized as a gain or loss. In effect, you redo the day-one calculation with updated terms.
Impairment
ROU assets under finance leases are long-lived assets and follow the same impairment rules as property, plant, and equipment under ASC 360. If the carrying value may not be recoverable — the asset is underperforming, market conditions have shifted, or you’re planning to return it early — test for impairment. If you record an impairment charge, recalculate amortization going forward based on the new lower carrying value. The lease liability itself isn’t affected by impairment of the asset.