A lessee is required to capitalize a lease if ANY of the following conditions are met:
- Lease ownership is transferred to the lessee at the end of the lease term.
- There is a bargain purchase option in the lease contract where the lessee may buy the asset at or below fair market value at the end of the lease.
- The present value of the lessee’s minimum payments, over the life of the lease, equal 90% or more of the asset’s fair market value.
- The lease’s term is equal to 75% or more of the useful economic life of the asset.
Operating Lease Accounting for the Lessee
The annual rental expense appears on the lessee’s income statement and there is no balance sheet asset and liability associated with the lease.
- An operating lease affects the lessee’s balance sheet only in an indirect matter. The rental expense lowers net income, which in turn lowers the company’s retained earnings in the equity section of the balance sheet.
- Rental payments on an operating lease are treated as part of operating cash flows.
Capital Lease Accounting for the Lessee
If one of the above four conditions is met in the US, the lessee is required to account for the transaction as if it were a long-lived asset purchased on credit.
- The lessee’s capital lease creates journal entries for interest expense, lease repayment (which decreases the lease obligation on the balance sheet over time), and depreciation.
- Typically, a capital lease will front load expenses associated with the asset, which causes the lessee’s net income to rise over time.
- At a capital lease’s expiration, the lessee’s balance sheet will be no different than the balance sheet where the lease was classified as operating, but in the time between lease initiation and expiration, the capital lease creates a balance sheet asset and liability.
- Under a capital lease, the interest expense attributed to the lease payment is an operating cash flow, but the principal repayment of the lease obligation is a financing cash outflow.
- The capital lease payment to be made within one year is separated as a short-term liability and the remaining lease balance is classified as a long-term liability on the balance sheet.
U.S. and international accounting standards may require some form of financial statement footnote disclosure regarding the company’s lease accounting practices.
A common financial statement adjustment made by analysts is to capitalize operating leases presented in the footnotes, creating a balance sheet asset and liability equal to the future payments required by the operating leases.