background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024
:
Private EquityReal Estate Investing
Buy-Side InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open
Wall Street Prep

Capital Lease

Step-by-Step Guide to Understanding the Capital Lease vs. Operating Lease Concept

Last Updated January 7, 2024

Learn Online Now

Capital Lease

How Do Capital Leases Work?

A capital lease, or “finance lease”, is a long-term contractual agreement, where a lessee rents a non-current fixed asset (PP&E) from a lessor for a pre-determined period in exchange for periodic interest payments.

Often, corporations rent assets such as offices, equipment, and vehicles because renting is more economically viable than purchasing the asset outright. The lease payment obligations occur throughout the term of the lease, whereas a purchase signifies a lump sum, one-time outflow of cash.

Suppose that at the end of the lease term, the ownership of the leased equipment is anticipated to transfer to the lessee – i.e. a corporation – upon receipt of the final lease installment payment.

Considering the leasing agreement features an ownership transfer – one of the conditions that qualify a lease as a capital lease – the lease is treated throughout the lease term as if the corporation is the owner. The corporation is therefore obligated to capitalize the lease on its financial statements to comply with U.S. GAAP accounting standards.

Because of the terms surrounding the leasing arrangement, the corporation is treated as the owner of the asset for accounting purposes, despite technically “leasing” the asset from the lessor (and legally, the asset still belongs to the lessor).

What is the Accounting for Capital Leases?

Under U.S. GAAP accounting rules, a capital lease is an agreement where the lessee possesses certain ownership characteristics, resulting in its financial statements treating the fixed asset (PP&E) as if the lessee was the actual owner.

The lessee refers to the party renting the asset from another, the true owner of the asset, or lessor.

From the perspective of the lessor, the asset is leased while all the other ownership rights are transferred to the lessee.

The criteria set under U.S. GAAP for an asset to receive treatment as a capital lease states that one of the following four conditions is required to be met:

  • Ownership Transfer → Once the lease term ends, the ownership of the asset is transferred from the lessor to the lessee.
  • Bargain Purchase → The lessee is offered the option to purchase the leased asset at a discounted, below-market price at the end of the lease term.
  • Lease Term → The term of the lease is equal to or exceeds 75% of the useful life assumption of the leased asset.
  • Present Value of Lease Payments → The present value of the periodic lease payments is equal to or greater than 90% of the asset’s fair market value (FMV), as of the starting date of the lease.

How Do Capital Leases Impact the Financial Statements?

Per U.S. GAAP reporting standards, the present value (PV) of the future lease payments associated with the arrangement represents the carrying value of the fixed asset (PP&E).

  • Balance Sheet → The present value (PV) of the lease payments is recognized as a long-term fixed asset, with the offsetting entry being a “credit” to the capital lease liability account. Since the value of the leased asset is recorded in the assets section and the capital lease of equal value is recorded in the liabilities section, the accounting equation remains true (i.e. assets = liabilities + equity).
  • Income Statement → The lessee recognizes a depreciation expense throughout the leasing term, which will be embedded within the cost of goods sold (COGS) or operating expenses line item, as well as the implied interest expense. Unlike traditional debt instruments, lease payments rarely state an explicit interest amount, meaning the interest expense must be estimated. The depreciation expense reduces the carrying value of the fixed asset on its balance sheet. By the end of the lease term, the balances of the fixed asset and offsetting lease liability account should reach zero.
  • Cash Flow Statement → Because depreciation is a non-cash expense, it is treated as an add-back on the cash flow statement. Moreover, the cash outflows related to the lease payments are tracked.

Note: Under IFRS, capital leases are termed “finance leases”, and the criteria are similar yet NOT identical.

Capital Lease vs. Operating Lease: What is the Difference?

With a capital lease, the lessee is required to record the leased asset on its balance sheet because the lease establishes them as practically the owner, i.e. one of the conditions set under GAAP is met.

In contrast, lease agreements without ownership characteristics is an operating lease.

The distinction between capital leases and operating leases merely comes down to whether there are ownership characteristics, which determine the presentation of the lease on the financial statements.

While a capital lease is treated as an asset on the lessee’s balance sheet, an operating lease remains off the balance sheet.

  • Capital Lease → Capitalized on Balance Sheet
  • Operating Lease → “Off Balance Sheet” Item

Conceptually, a capital lease can be thought of as ownership of a rented asset, while an operating lease is like renting any type of asset in the normal course.

With an operating lease, the lessee does not record the leased assets on its balance sheet since there are no ownership characteristics. Instead, the rental expense associated with the lease is recognized on the income statement in the period incurred, and each payment is tracked on the cash flow statement.

The notable difference between a capital lease and an operating lease is that for an operating lease, the asset must be returned to the owner at the end of the lease term.

  • Balance Sheet → Initially, the operating lease is recorded as a liability on the balance sheet, similar to debt.
  • Income Statement → The income statement is where the accounting treatment is different between operating and capital leases, as the lease expense (or rental expense) is recorded throughout the lease term.
  • Cash Flow Statement → The cash flow statement reflects the lease payments through the net income line (i.e. the “bottom line”), so the lease payment affects the CFS via the cash flow from operations section.

Learn MoreOperating vs. Capital Leases (Damodaran)

Capital Lease Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

dl

By submitting this form, you consent to receive email from Wall Street Prep and agree to our terms of use and privacy policy.

Submitting...

Capital Lease Calculation Example

Suppose a company has agreed to borrow an asset for a four-year lease term with an annual rental expense of $100,000 and an implicit interest rate of 3.0%.

  • Annual Lease Rental Expense = $100k
  • Implicit Interest Rate = 3.0%

If we assume the lease meets the criteria to be treated as a capital lease, what are the appropriate adjustments to the three financial statements?

The first step is to estimate the carrying value of the right-of-use (ROU) asset, approximated as the net present value (NPV) of all future rental expenses.

  • Remaining Lease Payments, Year 0 = $100k × 4 Years = $400k

Using the present value (PV) function in Excel, we can compute the right-of-use (ROU) asset as $372k as of the opening date, which refers to the end-of-period balance in Year 0.

The offsetting entry recorded is the capital lease liability account, which we’ll set equal to the ROU asset, i.e. link to the $372k from the prior step.

  • Right-of-Use Asset (ROU) = $372k
  • Capital Lease Liability = $372k

From Year 1 to Year 4 – the four-year lease term – the ROU asset is reduced by the depreciation expense until the asset’s value declines to zero (i.e. “straight-lined”), meaning that the annual depreciation is $93k per year.

  • Depreciation Expense = $372k ÷ 4 Years = $93k

The opening balance of the right-of-use asset (ROU) is reduced by the annual depreciation amount each year.

  • Ending ROU Asset = Beginning ROU Asset – Depreciation Expense

The capital lease liability does not have an explicit interest schedule, so we must estimate the imputed interest expense, which equals the difference between 1) the remaining lease payments and 2) the present value of the remaining lease payments.

  • Total Imputed Interest Expense, Year 0 = $400k – $372k = $28k

For the remainder of the lease term, the imputed interest expense will be calculated using the same methodology in order to determine the interest expense paid per year.

The interest expense recorded on the income statement is equal to the difference in the imputed interest expense between the prior and current year.

  • Interest Expense = Prior Year Imputed Interest – Current Year Imputed Interest

For example, the interest expense in Year 1 is $11k, which we calculated using the following equation.

  • Interest Expense, Year 1 = $28k – $17k = $11k

With our interest expense forecast complete, the remaining step is to calculate the capital lease payment, which is captured on the cash flow statement.

  • Capital Lease Payment = Annual Lease Payment – Interest Expense

The capital lease liability on the balance sheet is reduced by the capital lease payment each period until the lease term ends.

  • Capital Lease Liability = Beginning Capital Lease Liability – Capital Lease Payment

By the end of our forecast, we can see that the right-of-use asset (ROU) and the capital lease liability have declined to an ending balance of zero in Year 4.

The capital lease payment – the outflow recorded on the cash flow statement – equals the difference between the annual lease payment and the interest expense payment.

Each year, the sum of the lease Interest expense and the lease payment must equal the annual lease expense, which we confirm at the bottom of our model.

Model Check = Annual Lease Payment (Interest Expense + Capital Lease Payment)

Our model confirms that the interest expense and capital lease payment is $100k each period, which is equivalent to the $100k annual lease payment.

Capital Lease Accounting Model Calculator

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
6 Comments
most voted
newest oldest
Inline Feedbacks
View all comments
Kzh10
March 23, 2024 1:34 am

Where does that PV come from
? I mean 400 / (1,03^4) = 355, not 372 ?
I’m having a hard time calculating interests .. :/

Brad Barlow
March 28, 2024 1:30 pm
Reply to  Kzh10

The lease payments are $100/year spread over 5 years, but the first payment is immediate, and the remaining are at the end of years 1-4, so your PV formula needs to sum up the PV of each lease payment, years 0-4, at 3%.

BB

Archie
January 7, 2024 7:38 pm

How did you get to 372,000 for the PV of 400,000?

Brad Barlow
March 28, 2024 1:30 pm
Reply to  Archie

Hi, Archie,

The lease payments are $100/year spread over 5 years, but the first payment is immediate, and the remaining are at the end of years 1-4, so your PV formula needs to sum up the PV of each lease payment, years 0-4, at 3%.

BB

Bobare
August 8, 2023 5:23 am

Why are the 2 balance sheet data entries (ROU & Capital Lease Liability) different? Thanks!

Brad Barlow
August 8, 2023 10:49 pm
Reply to  Bobare

Hi, Bobare,

The lease liability is reduced by the principal payment, which may vary from year to year, whereas the ROU asset is depreciated on a straightline basis over the life of the asset.

BB

Learn Advanced Accounting Online

Master accounting topics that pose a particular challenge to finance professionals.

Learn More

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.