Capitalized Lease Method: Definition, Meaning & Effects

KEY TAKEAWAYS

• A capitalized lease is a type of long-term lease in which the lessee agrees to make periodic payments. 
• The payments are equal to or greater than the amount of depreciation on the leased asset plus interest. 
• The lessee also agrees to pay all taxes, insurance, and maintenance costs associated with the leased asset. 
• The lease agreement may also require the lessee to purchase the leased asset at the end of the lease term. 
• Capitalized leases are often used when a company needs to lease an expensive piece of equipment.

What Is a Capitalized Lease Method?

Under the capitalized lease method, the lessee recognizes a lease asset and a corresponding lease liability. This goes on the balance sheet. The lessee’s periodic payments are then allocated. This is between interest expense and reduction of the lease liability.

Consider recognition of interest expense and reduction of the lease liability. These two result in a constant debt service schedule during the term of the lease.

The capitalized lease method is most commonly used for real estate leases, but can also go to vehicles and equipment. Capitalized leases are also sometimes referred to as “finance leases.”

The capitalized lease method has a number of advantages for both lessees and lessors. We will discuss these and more below, so keep reading to learn more.

How the Capitalized Lease Method Works

The capitalized lease method is a type of accounting to account for leases. Under this method, the lessee recognizes a lease asset and a corresponding lease liability on the balance sheet. The lessee’s periodic payments are then allocated.

This is between interest expense and reduction of the lease liability. This results in a constant debt service schedule during the term of the lease.

Now, we look at the capitalized lease method. Here, depreciation expenses and periodic lease payments are sources of taxable income. This method accounts for long-term leases, such as those involving real estate or expensive equipment.

Now, on to the capitalized lease method. This results in higher depreciation expenses and lower periodic lease payments. Especially compared to the straight-line method. As a result, taxable income increases in the early years of the lease contract and decreases in the later years.

The capitalized lease method is often used by businesses that want to minimize their taxes in the early years of a lease. By deferring some of the depreciation expense to later years, businesses can reduce their taxable income in the short term.

However, this means that more depreciation expenses are in the later years of the lease, which could lead to a higher tax bill.

Businesses should consider if capitalized lease is the best option. This method may not be suitable for all businesses, particularly those that do not have a long-term need for the leased asset.

In addition, businesses should be aware of the potential for higher taxes in the later years of the lease. Nevertheless, the capitalized lease method can be a useful tool for businesses that want to minimize their taxes in the short term.

You want to be sure to add your lease obligations to your income statement. This is one of the accounting principles that ensures you understand your financial debt.

Such accounting rules help you maintain your longer-term assets and current liabilities. Public companies regularly balance their true lease management. This is true regardless of the types of leases they’re locked into.

Thus, it’s easier to keep up with annual lease payments. And in doing so, they’re less likely to fall behind on their lease obligations.

Benefits of a Capitalized Lease

There are a number of reasons why you might want to get a capitalized lease. For lessees, the main advantage is lower periodic payments. This is because the payment gets allocated. It is between interest and principal, rather than being fully applied to principal as with an operating lease.

In addition, the capitalized lease method results in a straight-line expense for the lessee. This means that the lessee can better predict its future expenses associated with the lease. For lessors, the capitalized lease method results in higher periodic payments.

This is because the interest portion of the payment gets applied to reduce the principal balance of the loan. As a result, lessors receive a higher return on their investment. In addition, the capitalized lease method results in a higher ending balance for the lease liability.

This can be beneficial for lessors when they go to sell the lease or refinance the property.

Use of Capitalized Lease

The capitalized lease is often used when a company needs to lease an expensive piece of equipment. Capitalized leases are also commonly used to finance real estate projects.

A capitalized lease is a long-term agreement between a lessee and a lessor. Here, the lessee makes periodic payments to the lessor, and the lessor uses the payments to finance the purchase of the leased asset. 

The total amount of the periodic payments is equal to or greater than the fair market value of an asset at the inception of the lease. The leased asset is recorded on the lessee’s balance sheet as an asset. The corresponding liability is reported on the lessor’s balance sheet.

Example of Capitalized Lease

To illustrate, let’s say that you want to lease a new car. You find a car that you like and negotiate a monthly payment of $500 for 36 months. Under the capitalized lease method, the total amount of the lease would get capitalized on your balance sheet.

This would result in a $18,000 asset and a $18,000 liability. Each month, a portion of your payment would get applied to interest expenses. The remaining portion would get applied to reduce the balance of your lease liability.

At the end of the term of the lease, you would have paid a total of $18,000 in periodic payments. Of this amount, $6,000 would have gotten applied to interest expenses. And $12,000 would have gotten applied to reduce the balance of your lease liability.

Summary

Capitalized leases are used when the lessee wants to own the asset at the end of the lease term. Moreover, when the periodic payments are equal to or greater than the fair market value of an asset. This type of lease is also used to finance the purchase of assets that will appreciate in value over time.