What are “Capital Leases”?
A lease is a contract for the use of an asset over a specified term. The lessee (the person who gets to use the asset) does not have legal title to the asset but could potentially have rights and obligations that are very similar to ownership. A lease spreads the cash cost of the asset over its life rather than being an upfront cash outflow as would be the case with an asset purchase.
Leases, which are similar to asset purchases in terms of the rights and obligations that the lessee has, are called capital or finance leases. A finance or capital lease comes with both the risk and rewards of ownership. For example, a capital lease of a machine allows the lessee to make money by selling products made by the machine. However, if the machine breaks down, it is the lessee’s responsibility to fix it.
Under US GAAP, if a lease does not qualify as a capital lease, then it is called an operating lease, which is similar to the rental of an asset and in which the lessee has no rights or obligations of ownership.
Key Learning Points
- Capital or finance leases are similar to asset purchases in terms of the rights and obligations of the lessee
- The classification rules for capital leases are the same in principle under US GAAP and IFRS. However, under IFRS the scope of assets that can be included for leasing is broader than US GAAP
- Capital leases affect both the balance sheet and income statement. At the beginning of the lease, both the assets and liabilities match with the lease amount shown as an asset and liability, respectively. At the end of the lease, the balance is zero on both sides of the balance sheet
- The accrued interest and depreciation expenses go to the income statement under the interest expense and depreciation expense lines
Capital Leases Explained
Capital leases are similar in economic substance to buying an asset and funding the purchase with debt. US GAAP and IFRS classification rules are the same in principle although there are some differences. Under IFRS, the following lease contract clauses are indicative of a financing or funding type lease:
- The lease term represents substantially all of the economic life of the asset
- The lessee is responsible for the normal costs of ownership g. insurance and maintenance
- The present value of the lease payments represents substantially all of the purchase price of the asset
- There is a transfer of legal title at the end of the lease
- There is a bargain purchase price option at the end of the lease
- The residual value at the end of the lease is minimal
Under US GAAP, some of the rules are more prescriptive. They include:
- Legal title transfers to the lessee
- The lease contains a bargain purchase option
- The lease term (only up to any break clause) is >75% of the economic life of the asset
- The present value of the minimum lease payments (only up to any break clause) > 90% of the asset’s fair value
Here is a brief explanation of some of the terms used above:
A break clause is a condition in a contract that allows its early termination before the agreed end date.
Fair value is the anticipated recoverable amount.
Bargain purchase refers to purchase at less than the fair value of an asset.
Capital Lease Accounting
The paragraphs below explain how a capital lease is treated in the financial statements of a company.
At the inception, the leased asset is capitalized in non-current assets on the balance sheet. The corresponding debt equivalent obligation is included in both current and non-current liabilities. The lease should be capitalized at fair value, if the fair value is known. In some cases (specialized assets, for example), the fair value may not be known. In which case the present value should be capitalized.
Most corporations show the lease liability as part of the debt, but some companies show it as a separate line item in liabilities. The lease obligation is accounted for as amortizing debt, where each repayment includes both principal and interest. The amount of the liability reduces each period by the principal repaid during that period.
The asset is depreciated over its life and expensed as an operating cost in COGS or SG&A as appropriate. This means that EBIT is after the depreciation component of finance or capital leases. The EBITDA is before any element of the cost of such a lease.
The interest is expensed into the income statement as part of the financing cost. This means it is “below the line” and does not impact either EBIT or EBITDA. The interest rate used is either that implicit in the lease or the incremental cost of borrowing.
Example: Capital Lease Accounting
Here are some assumptions about the capital lease of a company. We have been asked to work out the accounting for this capital lease under IFRS and US GAAP. While there are some differences in IFRS and US GAAP in what type of assets can be leased, the mechanics of accounting are similar under both.
The asset costs $90 million and is expected to last for 3 years. We have calculated the lease payments of $33 million each year using the payment function in Excel.
The lease liability starts at $90 million. Every year, the accrued interest is calculated by multiplying the implicit interest rate with the beginning balance. The cash payment for the lease is the same every year. The ending balance is calculated as the beginning balance + accrued interest fewer cash payments.
The leased asset is at $90 million in year 1 of the lease. Both assets and liabilities match at the beginning. However, in time, the leased asset is depreciated, typically on a straight-line basis. In this case, the depreciation expense will be 30 million each year.
Both the leased asset and liability at the end of year 3 are at 0.
If you notice, the balance sheet does not balance at the end of year 1 and year 2. The income statement picks up the accrued interest that is being expensed in the lease liability and the depreciation being expensed as part of the leased asset. These two items will go to the income statement under the interest expense and depreciation expense lines. The sum of total interest expense and depreciation expense over the three years will equal the total cash payment over the period.