The concept of leasing is well recognized as a crucial and widely used method of obtaining financial backing.
Leasing is a versatile option that helps organizations make use of assets like property and equipment without making large upfront investments. It also provides lessees with a means of mitigating the risks of depreciation and diminished value.
In some instances, leasing may be the only option for gaining access to a needed physical asset.
This article talks about the capitalized lease method, discusses capitalized lease obligations, explains its workings, and uses an example to illustrate the concept. So let's get into it.
Fundamentally, the lease obligation of a corporation gets recorded as an asset under this method of accounting. Before getting deeper into the method, let's understand the implications of capitalized lease obligations.
Any lease payments similar in frequency to interest and principal payments are considered capitalized lease obligations since they result from the leasing of long-term assets under contract.
For this reason, capitalized leases fall within the category of long-term debt.
Capitalized leases are distinct from operational leases in the sense that the tenant takes complete authority and right of use of the leased asset.
On the hand, in an operating lease, the tenant just receives the right to use the property. Leased assets are treated as depreciable assets when they get classified as capitalized.
Liabilities arising from contracts are shown in the 'current' portion of long-term debt, which includes any commitments with a maturity date of one year.
Now, coming back to the capitalized lease method, if the lease agreement meets one of the four requirements established by the Financial Accounting Standards Board (FASB), the lessee is required to record the lease agreement as an asset capitalization.
If the following conditions are met, then the asset should be capitalized:
The capitalized lease method serves as an efficient method of accounting for leases. In this scenario, the lessee will have a lease asset and a lease liability on their books. Afterward, the lessee's periodic installments are specified.
It's a trade-off between interest payments and principal payments toward the leasing obligation. There will be no changes to the repayment plan for the debt over the lease's duration.
In the capitalized lease method, taxable income gets generated from two areas: depreciation and regular lease payments.
This method takes into consideration the unique circumstances of long-term leases for assets like property and costly machinery.
It implies more depreciation costs and fewer lease payments over time, in particular when compared to the straight-line method. Consequently, the taxable income rises in the first few years of the lease and falls off in the latter ones.
Many companies prefer to capitalize their lease payments in the initial years of a lease contract to reduce their tax liability.
Businesses can minimize their current taxable revenue by postponing some of their depreciation expenses until subsequent years. However, it could result in greater tax liability, suggesting that a large proportion of the depreciation costs would be incurred later in the lease.
While a capitalized lease may be the best choice for some businesses, it must be carefully considered. Not all companies will be good candidates for this approach, especially if they don't anticipate long-term use for the leased asset.
Additionally, companies should anticipate paying more taxes during the lease's later years. While the capitalized lease method may not be the best long-term solution, it can help companies reduce their tax liabilities in the short run.
Accounting teams must ensure to incorporate capitalized lease obligations in their income statement. One of the main objectives of accounting for leases is to help businesses gain a clear picture of their financial obligations.
Long-term assets and existing liabilities could be tracked with the help of such accounting standards.
True lease management is a frequent practice for publicly traded corporations. It holds true despite the variety of leases they're obligated to fulfill.
As a result, annual leasing payments are more manageable. They will be less inclined to neglect their lease payments if they practice this approach.
This accounting technique involves some significant modifications to several financial ratios used by accountants, auditors, and analysts.
For instance, professionals determine the proportion of a corporation's total debt that has to be serviced off over the next twelve months by dividing the ratio of the company's current obligations by its total debt.
This ratio shifts as a result of the lease obligation because a capitalized lease adds to liabilities. This shift in the ratio may also cause analysts' judgments of the company's equity to fluctuate.
Consider an example where a company wants to lease a new vehicle.
If the lessee intends to purchase the asset after the lease term expires, and the asset value is maintained through regular payments that are greater than or equal to the asset's current market valuation, then a capitalized lease should be utilized.
Companies can also finance the acquisition of assets expected to increase in value with time for this sort of lease.