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QuickBooks and Capital Leases

L. Keith Jordan
I recently answered a question on the QuickBooks forums concerning how to handle a lease with a $1 buyout. I would like to address this issue here.

[NOTE: Although this article specifically concerns capital leases, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are moving toward changes to accounting for operating leases that will, in effect, require them to be treated similarly to capital leases. This article therefore may be considered potentially relevant in both situations.]

There are essentially two types of leases: 1) operating (aka "off-balance sheet"); and 2) capital. Title to subject property in an operating lease remains with the lessor. In a capital lease, title to the subject property is intended to eventually pass to the lessee/purchaser (barring default by the lessee/purchaser). Which party bears responsibility for items such as maintenance, insurance, and taxes depends on the type of lease and the terms of the agreement between the parties.

Currently, operating lease payments appear on the income statement as expenses. Capital lease obligations, on the other hand, appear on the balance sheet and principal payments serve to reduce those obligations while interest payments are recorded as expenses reported on the income statement.

Either type of lease may include an option to purchase the subject property at the end of (or perhaps during) the term. Under normal circumstances, the purchase option price approximates the fair market value (FMV) of the subject property. In the case of a bargain purchase option, however, the buyout option payment is substantially below FMV (as is the case for a lease with a $1 buyout). In such a case, the lease is considered to be of the capital variety.

In QuickBooks, a capital lease is established by a) creating a fixed asset account for the subject property (and depreciating, as appropriate); and b) creating a long-term liability account for the obligation. Payments are allocated between principal and interest according to an amortization schedule, or equivalent information provided by the lessor.

QuickBooks users may choose to use the QuickBooks Loan Manager to help manage the obligation and payment allocation to principal and interest. If so, care should be observed to observe the appropriate steps (via Help) to ensure that Loan Manager can do its job properly.

There is a drawback to QuickBooks Loan Manager, however. The Loan Manager does not distinguish between the current and non-current portion of the obligation. Recognition of the current portion of the obligation for financial statement purposes may require custom preparation of financial statements. Formal, published financial statements often require external CPA involvement, so this issue will probably not present a problem -- particularly if statements are prepared solely for in-house use.