What is a 'Capitalized Lease Method'

A capitalized lease method is an accounting approach that posts a company's lease obligation as an asset on the balance sheet. If the lease agreement meets at least one of the four criteria provided by the Financial Accounting Standards Board (FASB), the lease is capitalized, which means that the lessee (the company leasing the asset) recognizes both depreciation expense and interest expense on the lease. While an operating lease expenses the lease payments immediately, a capitalized lease delays recognition of the expense.

BREAKING DOWN 'Capitalized Lease Method'

When a lease is capitalized, the lessee creates an asset account for the leased item, and the asset value on the balance sheet is the lesser of fair market value or the present value of the lease payments. The lessee also posts a lease obligation in the liability section of the balance sheet for the same dollar amount as the asset. Over time, the leased asset is depreciated and the book value declines.

Examples of Capitalized Assets

If a lessee automatically gains ownership of the asset at the end of the lease, or if the lessee can buy the asset at a bargain price at the end of the lease, the lease should be capitalized. A lease should also be capitalized if the lease runs for 75% or more of the asset's useful life, or if the present value of the lease payments is at least 90% of the asset's fair market value when the lease is created.

How a Capitalized Lease Works

Assume, for example, that a company has a lease obligation of $540,000 for five years with an interest rate of 10%. The company must make five payments of $90,000, and these payments are comprised of both the interest payments and the principal payments. The interest payments are 10% of the lease balance, and the remainder of each payment pays down the principal balance. The first-year interest expense is $54,000 ($540,000 x 0.1), and the other $36,000 of the payment reduces the principal amount of the lease. The lease obligation's amortization schedule reduces the $540,000 lease obligation by $36,000, so that the obligation for the second 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.

Factoring in the Balance Sheet Impact

A capital lease means that both an asset and a liability are posted to the accounting records. This accounting treatment changes some important financial ratios used by analysts. For example, analysts use the ratio of current liabilities divided by total debt to assess the percentage of total company debt that must be paid within 12 months. Since a capitalized lease increases liabilities, the lease obligation changes this ratio, which may also change analysts opinions on the company's stock.

RELATED TERMS
  1. Lease Payments

    Lease payments are tied to the terms of different forms of leasing ...
  2. Bargain Purchase Option

    A bargain purchase option in a lease agreement allows the lessee ...
  3. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
  4. Walk-Away Lease

    A common type of car lease in which the lessee returns the car ...
  5. Minimum Lease Payments

    The minimum lease payment is the lowest amount that a lessee ...
  6. Open-End Lease

    An open-end lease is an agreement that requires the lessee to ...
Related Articles
  1. Managing Wealth

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  2. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  3. Managing Wealth

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  4. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  5. Personal Finance

    Make the Right Choice: Buying or Leasing a Car

    Ask yourself these questions before deciding between leasing or buying a car.
  6. Managing Wealth

    4 Ways to Get the Best Deal on a Car Lease

    Car buyers typically negotiate when purchasing a vehicle, but many don't negotiate when leasing a car. There are several ways to save if you ask.
  7. Managing Wealth

    Your Lease Is Up: When Should You Buy The Car?

    In general, the fact that you know the car is to your benefit. Before deciding, compare the buyback price to what the car would go for on the open market.
  8. Insights

    Companies With Big Hidden Debts

    Companies with off-balance sheet debt will be brought to light when new rules come into effect in 2019.
  9. Personal Finance

    Should You Buy or Lease a New Car?

    Deciding whether to lease or purchase a car depends on a number of factors.
  10. Personal Finance

    3 Questions to Consider When Buying a Car

    When deciding what kind of car to buy, make sure to answer these questions first.
RELATED FAQS
  1. What are the differences between single, double and triple net leases?

    Learn the ins and outs of net lease agreements, including the key differences between single net, double net and triple net ... Read Answer >>
  2. What are typical forms of long-term debt for a public company?

    Learn typical forms of long-term debt for a public company, such as bonds, term loans, paid-in-kind notes, leases and hybrid ... Read Answer >>
  3. If a telecommunication company wants to build a tower on my land how much should ...

    Get help in understanding how much income it is possible to receive for leasing land to a telecommunications company for ... Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center