When your company must buy expensive equipment, it can pay with cash or use a form of credit. Two forms of credit are a promissory note and a capital lease. Both show up as long-term liabilities on the balance sheet, but the bookkeeping for payments differs between the two forms of financing.
You can arrange a loan to purchase equipment. If the equipment seller offers financing terms, you debit equipment and credit notes payable for the loan amount. Equipment is a long-term asset, and notes payable is a liability. A note is a long-term liability if its term is longer than one year. You periodically pay interest on the note by debiting interest expense and crediting cash or interest payable. At maturity, you pay back the principal amount by debiting notes payable and crediting cash. Alternatively, you can arrange financing with a bank and pay for the equipment with the loan proceeds; the notes payable then references the bank rather than the equipment seller.
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A capital lease also creates a liability. A capital lease is one that meets one of the following conditions: The equipment transfers to the lessee at the end of the lease; lease payments total at least 90 percent of the present value of the equipment's fair value; the lease term extends over at least three-quarters of the equipment's useful life; or the lease contains a provision for you to buy the equipment at a bargain price before the lease terminates. When you sign a capital lease, you enter a debit to equipment and a credit to capital lease obligation, which shows on the balance sheet as a short- or long-term liability, depending on the lease's term.
Unlike interest payments on notes, a lease payment contains a mix of principal and interest. The size of the lease liability is the present value of the minimum lease payments, discounted at an interest rate comparable to that of a note with the same terms. However, the lease obligation cannot exceed the fair value of the equipment, which is the price the equipment would fetch on the open market. The lessee reduces, or amortizes, the capital lease obligation each month by the amount of the lease payment designated as principal; the lessee records the balance of each payment as interest expense. At the end of the lease term, the capital lease obligation has a zero balance.
Whether purchased via a note or a capital lease, the equipment belongs to the buyer, who must depreciate it. The monthly depreciation expense is added to the contra-asset account called accumulated depreciation, which appears right below the equipment line on the balance sheet's long-term asset section. You can depreciate the equipment using either the straight-line method or a declining-balance method. The equipment remains on the balance sheet until you dispose of it. If you sell the equipment for other than its balance sheet carrying amount, you must record a capital gain or loss on the sale.