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| Capitalized Lease Method |
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An accounting approach that identifies a company's lease obligation as an asset on its balance sheet. This is done because although the company has not taken ownership of the asset, the transaction is still considered to be a beneficial economic exchange for the lease holder. Under this method, the expenses are higher in the early years and gradually decline over the term of the lease. |
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For example, assume that a company has a lease obligation of $500,000 for 10 years, with an interest rate of 10%. The company must make 10 payments of $81,372.70. These payments are comprised of both the interest payments and the principal payments. The interest payments are 10% of the lease balance. For example, the first interest expense is $50,000 ($500,000 x .10). The yearly payment less the interest expense is the principal payment, which reduces the lease balance. The lease is also amortized according to the company's respective amortization schedule. Assuming a straight-line schedule, the yearly amortization will be $50,000 ($500,000/10 years). Finally, the total annual capital lease expense that is realized by the company is equal to the interest expense plus the amortization, which is $100,000 ($50,000 + $50,000) for the first year. This annual expense will continue to decrease over the life of the lease. |
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