How to Capitalize Lease Payments

by Michael Dreiser

Both U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) require that financial reporting entities must capitalize certain operating leases that transfer the majority of the economic benefits and the risks and rewards of ownership to the lessee. The process of capitalization involves recording the value of the leased asset on the balance sheet of the financial reporting entity.

1. Using the lease, identify the series of periodic payments -- both by date and amount -- required under the lease. Only minimum, required payments should be listed. Variable payments that are dependent on the occurrence of third-party events should not be included.

2. Determine the imputed interest rate that will be utilized to record the lease. There is no singular methodology that should be used. Often, financial reporting entities will use a rate equal to the entity's marginal cost of borrowing. Alternatively, the financial reporting entity may use a cost of borrowing equal to that incurred by similar credit risk entities borrowing to purchase an asset similar to the leased asset. Finally, if the value of the asset is known, the difference between the asset's current value and aggregate total lease payments may be used to impute an interest rate.

3. Based on the interest rate and the series of periodic payments abstracted from the lease, assign an interest and principal value to each periodic payment under the lease. Typically loan amortization software is used to assign this value, although the values may also be assigned using functions available on most financial spreadsheet software.

4. Aggregate all of the principal payments.

5. Make a journal entry to debit the balance sheet to reflect a capital asset for the value of the aggregate principal payments. The offsetting credit is the lease payable obligation.

6. Credit the value of the capital asset and debit the value of the lease payable obligation each time a loan payment is made. Since cash is credited for each payment, the value of each capital asset credit and lease payable obligation payable debit is determined by the interest and principal values.

Items you will need

  • Copy of the lease

About the Author

Michael Dreiser started writing professionally in 2010. He is a certified public accountant with experience working for a large New York City accountancy and expertise in areas ranging from private equity taxation to investment management. He holds a Master of Business Administration in international finance from l’École Nationale des Ponts et Chaussées in Paris.

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