Capitalized Lease Method

What Is a Capitalized Lease Method?

The capitalized lease method is an accounting approach that posts a company's lease obligation as an asset on the balance sheet. Assuming the lease agreement meets something like one of the four criteria given by the Financial Accounting Standards Board (FASB), the lease is capitalized, and that means that the lessee (the company leasing the asset from another) perceives both depreciation expense and interest expense on the lease.

How the Capitalized Lease Method Works

While an operating lease expenses the lease payments right away, a capitalized lease postpones recognition of the expense. Basically, a capital lease is viewed as a purchase of an asset, while a operating lease is dealt with as a true lease under generally accepted accounting principles (GAAP).

At the point when a lease is capitalized, the lessee makes an asset account for the leased thing, and the asset value on the balance sheet is the lesser of the fair market value or the current value of the lease payments. The lessee likewise posts a lease obligation in the liability section of the balance sheet for a similar dollar amount as the asset. After some time, the leased asset is depreciated and the book value declines.

A lessee must capitalize a leased asset in the event that the lease contract went into fulfills something like one of the four criteria distributed by the Financial Accounting Standards Board (FASB). An asset ought to be capitalized if:

The lessee consequently gains ownership of the asset toward the finish of the lease.
The lessee can buy the asset at a bargain price toward the finish of the lease.
The lease runs for 75% or a greater amount of the asset's helpful life.
The current value of the lease payments is somewhere around 90% of the asset's fair market value when the lease is made.

A capital lease means that both an asset and a liability are posted to the accounting records.

Special Considerations

This accounting treatment changes a few important financial ratios utilized by analysts. For instance, analysts utilize the ratio of current liabilities isolated by total debt to survey the percentage of total company debt that must be paid in 12 months or less. Since a capitalized lease increments liabilities, the lease obligation changes this ratio, which may likewise change analysts' perspectives on the company's stock.

Illustration of How a Capitalized Lease Works

Expect, for instance, that a company has a lease obligation of $540,000 for a very long time with an interest rate of 10%. The company must make five payments of $90,000, and these payments are contained both the interest payments and the principal payments. The interest payments are 10% of the lease balance, and the remainder of every payment settles the principal balance.

The first-year interest expense is $54,000 ($540,000 x 0.1), and the other $36,000 of the payment diminishes the principal amount of the lease. The lease obligation's amortization schedule diminishes the $540,000 lease obligation by $36,000 so the obligation for the subsequent year is $504,000. The total capital lease expense is $54,000 in interest expense, plus $36,000 in lease amortization expense, for a total of $90,000.

Features

The capitalized lease method is an accounting approach that posts a company's lease obligation as an asset on the balance sheet.
An operating lease expenses the lease payments right away, yet a capitalized lease postpones recognition of the expense.
A lessee must capitalize leased assets in the event that the lease contract went into fulfills no less than one of the four criteria distributed by the Financial Accounting Standards Board (FASB).