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. 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 from another) 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. In essence, a capital lease is considered a purchase of an asset, while an operating lease is handled as a true lease under generally accepted accounting principles (GAAP).
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 the 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.
When to Capitalize Assets
A lessee must capitalize a leased asset if the lease contract entered into satisfies at least one of the four criteria published by the Financial Accounting Standards Board (FASB). An asset should be capitalize if:
1. The lessee automatically gains ownership of the asset at the end of the lease.
3. The lessee can buy the asset at a bargain price at the end of the lease.
2. The lease runs for 75% or more of the asset's useful life.
3. 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.