What it means
Under this method the lessee first measures the present value of the payments it has committed to make. That amount is recorded on day one as both a right-of-use asset and a lease liability.
From then on the two sides are handled separately. The asset is amortised across the lease term or useful life, while the liability is unwound like a loan, with each payment split between interest and principal.
Classification matters because it changes the shape of the reported expense. A capitalised lease front-loads cost, since interest is highest when the liability is at its largest, whereas a rental treatment spreads an equal charge across every year.
The reason standard setters pushed towards capitalisation is straightforward. Companies once leased fleets, aircraft and shop premises worth billions with no trace on the balance sheet, which made their borrowings and asset intensity look far smaller than they really were.
Watch the knock-on effects on ratios and loan covenants. Capitalising leases raises reported debt and total assets, lowers return on assets, and moves rent out of operating costs into depreciation and interest, which flatters measures such as EBITDA.
In practice
Real-world examples.
Example
A haulage operator leases twelve trucks on five-year contracts with a bargain purchase option at the end. Because the option makes eventual ownership near certain, the leases are capitalised, adding $2,800,000 to both assets and debt and prompting a conversation with the bank about a gearing covenant.
Example
A retailer moving to a new reporting standard capitalises 240 store leases at once. Reported debt jumps sharply, EBITDA improves because rent leaves operating costs, and the investor relations team spends a quarter explaining that nothing about the underlying business changed.
Example
A hospital leases an imaging machine for seven years, close to its full useful life. The finance team capitalises the lease, recognises the machine as a right-of-use asset and amortises it over the lease term, matching the cost against the scan revenue it produces.
Formula
Calculation
Lease liability = Present value of the lease payments, discounted at the rate implicit in the lease
Annual interest = Opening lease liability x Discount rate
A logistics firm leases warehouse equipment for five years at $50,000 payable at the end of each year, with a discount rate of 6%.
The five-year annuity factor at 6% is 4.21236, so the present value is $50,000 x 4.21236 = $210,618. That figure is recorded as both a right-of-use asset and a lease liability.
Amortisation on a straight-line basis is $210,618 / 5 = $42,124 a year, rounded. Year one interest is $210,618 x 6% = $12,637, so the principal repaid is $50,000 - $12,637 = $37,363 and the closing liability is $210,618 - $37,363 = $173,255.
Across the whole lease, total payments of $50,000 x 5 = $250,000 split into $210,618 of principal and $39,382 of interest. First-year expense under this method is $42,124 of amortisation plus $12,637 of interest, which is $54,761, against a flat $50,000 rental charge if the lease had not been capitalised.Case study
Seen in the real world.
Colwyn Fabrications is a fictional metalwork business, offered here as an illustrative example. It leased a laser cutting cell for six years, and because the lease covered nearly the whole economic life of the machine, its accountants applied the capitalised lease method rather than treating the payments as rent.
The right-of-use asset and matching liability of $840,000 appeared on the balance sheet, and the company's debt-to-equity ratio moved from 0.9 to 1.4. Colwyn's lender had set a covenant at 1.25, and the breach was technical rather than financial, since neither cash flow nor the machine's productivity had changed at all.
The finance director went to the bank early with a schedule showing the lease payments, the split between interest and principal and the unchanged cash position. The covenant was redefined to measure gearing before lease capitalisation, and the episode became a standing reminder to check covenant definitions before signing any long lease.
Watch out
Common mistakes.
- Assuming lease accounting has no cash effect worth planning for. The cash is unchanged, but covenant tests, credit ratings and bonus metrics built on reported figures certainly are affected.
- Discounting the payments at the company's borrowing rate without checking the lease. The rate implicit in the lease is used where it can be determined, and only otherwise is an incremental borrowing rate applied.
- Forgetting that the expense pattern is front-loaded. Total cost over the lease is the same, but early years carry more expense than a flat rental charge would.
Questions
People also ask.
When must a lease be capitalised?
Broadly when it transfers ownership, contains a bargain purchase option, runs for most of the asset's useful life, or has payments worth substantially all of the asset's value.
What is a right-of-use asset?
It is the balance sheet asset representing the lessee's right to use the leased item for the agreed term, rather than ownership of the item itself.
Does this change the total cost of leasing?
No, it changes only the timing and the labels, splitting a single rental charge into amortisation and interest across the term.
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