What is a Capital Lease?
A Capital Lease represents a long-term contractual agreement, where a company (i.e. the lessee) can rent a fixed asset such as PP&E from another party (i.e. the lessor) for a specified period of time in exchange for periodic interest payments.
How 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 Statement?
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.
Capital Lease Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
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?
- 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.
Our model confirms that the interest expense and capital lease payment is $100k each period, which is equivalent to the $100k annual lease payment.