A contractor purchases equipment using a capital lease with a present value of $120,000. How should this be recorded on the balance sheet?
Correct Answer
D) As both an asset and liability
Capital leases are recorded as both an asset (equipment) and liability (lease obligation) on the balance sheet at the present value of lease payments, treating it similar to a purchase.
Why This Is the Correct Answer
Capital leases are treated as asset purchases for accounting purposes because the lessee effectively gains ownership rights to the equipment. Under accounting standards, when a lease meets capital lease criteria, it must be recorded on the balance sheet as both an asset (the equipment being leased) and a corresponding liability (the obligation to make future lease payments). The present value of $120,000 represents both the asset value and the initial liability amount. This dual recording reflects the economic substance of the transaction rather than just its legal form.
Why the Other Options Are Wrong
Option A: As a footnote disclosure only
Footnote disclosure alone is insufficient for capital leases because they represent material transactions that must be recognized on the face of the financial statements. While additional disclosures may be required in footnotes, the primary recording must be on the balance sheet.
Option C: As a liability only
Capital leases are not recorded as operating expenses because they represent asset acquisitions, not period expenses. Operating expenses are recorded on the income statement and reduce current period income, while capital leases create balance sheet assets that are depreciated over time.
Memory Technique
Think 'Capital = Both Sides' - capital leases go on both sides of the balance sheet (asset side and liability side)
Reference Hint
Look up 'Capital Leases' or 'Lease Accounting' in the accounting/financial management section of your contractor reference manual
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