How to Account for Capital Leases & Finance Leases

Historically, many lease agreements were kept off balance sheets, obscuring financial obligations. New accounting standards, ASC 842 for US GAAP and IFRS 16 internationally, now require most leases to be recognized on the balance sheet for greater transparency. This change aims to provide a more transparent view of a company’s financial obligations.

Under these updated standards, a lessee generally records a “right-of-use” (ROU) asset and a corresponding lease liability. The ROU asset represents the lessee’s right to use an underlying asset, while the lease liability reflects the financial obligation to make lease payments. This comprehensive recognition ensures that investors and other stakeholders have a clearer understanding of a company’s financial position and its commitments.

The term “capital lease” under previous standards has been replaced by “finance lease” under ASC 842, though the core concept of recognizing significant asset use and associated debt remains.

Classifying a Lease

Previous accounting standards categorized leases as capital or operating based on “bright-line tests.” Current standards, specifically ASC 842, have superseded these with five criteria to classify a lease as a finance lease. If any one criterion is met, it is considered a finance lease; otherwise, it is classified as an operating lease.

A lease is classified as a finance lease if any of the following five criteria are met:
Ownership of the underlying asset transfers to the lessee by the end of the lease term.
The lease includes a purchase option that the lessee is reasonably certain to exercise.
The lease term covers a major part of the underlying asset’s remaining economic life.
The present value of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the underlying asset’s fair value.
The underlying asset is specialized and will have no alternative use to the lessor at the end of the lease term.

Recording a Lease at Inception

At the beginning of a finance lease, a right-of-use (ROU) asset and a corresponding lease liability must be recognized on the balance sheet. This initial recognition involves calculating the present value of future lease payments. These payments include fixed payments, variable payments that depend on an index or rate, the exercise price of a purchase option if its exercise is reasonably certain, and any penalties for terminating the lease if such termination is probable.

To determine the present value, payments are discounted using the rate implicit in the lease. If this rate is not readily determinable, the lessee’s incremental borrowing rate is used. This is the rate the lessee would pay to borrow a similar amount over a similar term.

The initial lease liability is calculated as the present value of these future lease payments, discounted at the appropriate rate.

The initial ROU asset value is determined by adjusting the calculated lease liability. This involves adding any initial direct costs incurred by the lessee and any lease payments made before commencement. Lease incentives received from the lessor are subtracted.

Ongoing Accounting for a Lease

After initial recognition, finance lease accounting involves a “front-loaded” expense pattern, with higher expenses in earlier periods. This results from separately recognizing amortization of the right-of-use (ROU) asset and interest expense on the lease liability.

The ROU asset is amortized over the shorter of the lease term or the underlying asset’s useful life. If the lease transfers ownership or includes a reasonably certain purchase option, amortization occurs over the asset’s useful life.

Interest expense on the lease liability is recognized each period using the effective interest method. This applies a constant interest rate to the outstanding liability balance, resulting in decreasing interest expense as payments reduce the liability.

When a lease payment is made, it reduces the lease liability and includes an interest component. The payment is applied first to accrued interest, with the remainder reducing the principal balance.

These three components—amortization expense, interest expense, and the cash payment—are recorded each period. The combination of declining interest expense and consistent amortization results in the front-loaded total expense profile, differing from operating leases’ straight-line expense.

Reporting Lease Information

Finance leases significantly impact a company’s financial statements, requiring specific presentation and detailed disclosures. On the balance sheet, the right-of-use (ROU) asset is presented, often within property, plant, and equipment. The corresponding lease liability is recognized, separated into current and non-current portions.

On the income statement, finance lease expenses are separated into two components: amortization expense on the ROU asset and interest expense on the lease liability. This dual recognition leads to a front-loaded expense pattern over the lease term.

The statement of cash flows also reflects finance lease activities. The principal portion of lease payments is classified as a financing activity, while the interest portion is generally classified as an operating activity.

Beyond primary financial statements, extensive qualitative and quantitative disclosures are required in the notes for finance leases. These provide users a deeper understanding of leasing arrangements, including the nature of activities and significant judgments like lease term or discount rate determinations.

Quantitative disclosures include:
A maturity analysis of lease liabilities, showing future minimum lease payments.
The weighted-average remaining lease term.
The weighted-average discount rate used for finance leases.
Information about short-term and variable lease expense.