Capitalized Lease Method: Definition And Example Of How It Works

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Understanding the Capitalized Lease Method in Finance

When it comes to managing finances, understanding different accounting methods is crucial. One such method that often comes up in the world of finance is the Capitalized Lease Method. In this blog post, we will explore the definition of the Capitalized Lease Method and provide an example of how it works. By the end, you’ll have a clear understanding of this important financial concept.

What is the Capitalized Lease Method?

The Capitalized Lease Method, also known as the Finance Lease Method, is an accounting practice used to record and report leases in a company’s financial statements. It is commonly used when a lease arrangement meets certain criteria that make it more economically similar to a purchase of an asset rather than a rental agreement.

Under the Capitalized Lease Method, the lessee (the party leasing the asset) treats the lease as if they had purchased the asset using borrowed funds. The lease is recorded as an asset on the balance sheet, along with a corresponding liability representing the lease obligation. This approach allows for a more accurate reflection of the lessee’s financial position.

How Does the Capitalized Lease Method Work?

Let’s illustrate the Capitalized Lease Method with an example:

Company XYZ wants to acquire a new piece of equipment for its operations. Instead of purchasing the equipment outright, they decide to enter into a lease agreement. The lease terms state that the lease period is five years, with monthly payments of $1,000. The equipment’s fair market value is $50,000.

1. Company XYZ assesses whether the lease meets specific criteria to be classified as a capital lease. These criteria typically include:
   • The lease term is equal to or greater than 75% of the asset’s useful life.
   • The lease agreement includes a bargain purchase option, allowing the lessee to buy the asset at a significantly lower price than its fair market value.
   • The present value of the lease payments is equal to or greater than 90% of the asset’s fair market value.
   • The leased asset is of a specialized nature and is unlikely to have alternative uses for the lessor at the end of the lease term.
2. In this example, let’s assume that Company XYZ meets all the criteria, and the lease is classified as a capital lease.
3. Company XYZ records the leased asset on its balance sheet with the initial value of $50,000. This represents the present value of the lease payments.
4. A corresponding liability of $50,000 is also recorded on the balance sheet, representing the lease obligation.
5. Every month, Company XYZ makes lease payments of $1,000. A portion of these payments is allocated towards reducing the liability, while the remainder is expensed as interest.
6. At the end of the lease term, the asset and liability are fully extinguished from the balance sheet, and Company XYZ no longer has any obligations towards the leased equipment.

Conclusion

The Capitalized Lease Method is an important accounting approach used in finance to accurately reflect lease transactions in a company’s financial statements. By classifying certain leases as capital leases, businesses can provide a more comprehensive representation of their financial position. Understanding this method is essential for financial professionals and business owners alike.

I hope this blog post has provided you with a clear understanding of the Capitalized Lease Method and how it operates. Incorporating this information into your financial knowledge will enable you to make informed decisions and effectively manage your company’s lease agreements.

Thank you for reading!