What it means
Under this method the lessee records an asset equal to the present value of the lease payments, which is what those future payments are worth in today's money, and a lease liability for the same amount. The asset is then depreciated over its useful life or the lease term, while the liability is reduced as payments are made.
Each payment is split between interest and repayment of principal. The reason the rules exist is that a long lease on a critical asset is economically a purchase funded by debt.
Keeping it off the balance sheet made two companies with identical operations look very different, so standard setters moved towards capitalising such leases. Modern standards have largely retired the old operating and capital labels, but the mechanics described here are still what a finance lease does.
The classic tests ask whether ownership transfers at the end, whether there is a bargain purchase option, whether the lease term covers most of the asset's life, and whether the present value of the payments covers most of its fair value. Meeting any one of them pushes the lease into capitalisation.
Judgement enters mainly through the discount rate and the estimate of useful life. The profit effect is front-loaded, which surprises people the first time they see it.
Interest is highest when the liability is largest, so total expense in year one exceeds the cash payment and total expense in the final year falls below it. Over the whole lease the two approaches charge the same total, just on a different timetable.
Capitalising a lease also changes the ratios that lenders and investors watch. Gearing rises because a new liability appears, while operating profit improves because depreciation and interest sit below the rent line that used to be charged.
Anyone with debt covenants should check how they are defined before a large lease is signed.
In practice
Real-world examples.
Example
A haulage business leases ten trucks for seven years, which is almost their entire working life, with a nominal buyout at the end. The lease is capitalised, so $1,400,000 of assets and an equal liability appear on the balance sheet and the rent line disappears from the profit and loss account.
Example
A dental practice leases a scanner for three years with no purchase option and the equipment has a ten-year life. The lease fails the capitalisation tests and is treated as a straightforward rental, so the practice simply charges the monthly payment to expenses.
Example
A retailer signs a fifteen-year lease on a flagship store and its banking covenant limits net debt to three times earnings. The finance team models the capitalised lease liability first, finds the covenant would be breached at the proposed rent, and renegotiates a shorter term with a break clause before signing.
Formula
Calculation
Lease liability at inception = payment x [1 - (1 + r) to the power of -n] / r
Annual depreciation = asset value / lease term
Interest for a period = opening liability x r
Take a five-year lease on a delivery fleet with payments of $25,000 a year in arrears and a discount rate of 6%. The annuity factor is [1 - 0.747258] / 0.06 = 0.252742 / 0.06 = 4.212364, so both the asset and the liability are recorded at 25,000 x 4.212364 = $105,309. Depreciation is 105,309 / 5 = $21,062 a year and year-one interest is 105,309 x 0.06 = $6,319, giving a year-one charge of 21,062 + 6,319 = $27,381. That is $2,381 more than the $25,000 of cash paid, and by year five the charge falls below the cash payment, so the total over the lease is the same either way.Case study
Seen in the real world.
Brightmoor Logistics is an illustrative and clearly fictional regional carrier that leased 40 trailers over six years at $18,000 each a year. Under its old treatment the $720,000 annual payment was simply rent, and the business looked almost debt free to anyone reading the balance sheet.
When the leases were capitalised, the present value of the payments at a 7% discount rate added roughly $3,430,000 of assets and the same amount of liabilities. Gearing jumped from 12% to 46% overnight even though not one trailer or contract had changed.
Brightmoor's bank had written its covenant against reported net debt, so the finance director had to negotiate a revised definition before the next test date. The illustrative lesson is that a change in presentation can breach a real agreement, and the conversation with the lender should happen before the numbers are filed.
Watch out
Common mistakes.
- Charging the full lease payment to expenses after capitalising the lease, which double counts cost because the payment now reduces the liability rather than hitting profit.
- Using the lease term as the depreciation period when ownership passes at the end, in which case the asset should be depreciated over its longer useful life.
- Treating capitalisation as a cash event, when the cash paid each year is identical and only the presentation and the timing of the expense change.
Questions
People also ask.
Does capitalising a lease change the total cost of the asset?
No, it changes how and when the cost appears in the accounts, and the sum of depreciation plus interest over the lease equals the total payments made.
Which discount rate should be used?
The rate implicit in the lease if it can be determined, and otherwise the rate the business would pay to borrow a similar amount over a similar term against similar security.
Why does operating profit improve after capitalisation?
Because the rent charge is replaced by depreciation and interest, and interest sits below the operating profit line, so the operating measure flatters the business even though total profit is unchanged.
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