What are Capital Lease Obligations?
Capital Lease Obligations (also known as finance leases) arise when a company leases an asset under terms that effectively transfer ownership benefits-such as useful life and asset control-to the lessee. Under accounting standards (e.g., IFRS 16, ASC 842), these leases are recognized similarly to a purchase financed by debt.
Why are Capital Lease Obligations Important?
Capital Lease Obligations are important because they:
- Reflect True Economic Commitments: Show long-term debt-like obligations that impact leverage and cash flow.
- Affect Asset Base: Bring leased assets onto the balance sheet, increasing reported property, plant, and equipment and corresponding liabilities.
- Influence Financial Ratios: Impact metrics such as debt-to-equity, return on assets, and EBITDA by adding non-interest financing obligations.
How are Capital Lease Obligations Calculated?
On initial recognition, the liability and right-of-use asset are measured at the present value of lease payments:
Where future lease payments include:
- Fixed payments over the lease term.
- Variable payments based on an index or rate.
- Amounts expected under residual value guarantees.
- Purchase options reasonably certain to be exercised.
The discount rate is typically the lease’s implicit rate or the lessee’s incremental borrowing rate.
Additional Considerations
- Amortization and Interest Expense: Lease liabilities are amortized over the lease term, splitting each payment into interest expense and liability reduction.
- Lease Term and Options: Extensions, renewals, or early termination options affect the liability measurement and assessment of lease term.
- Disclosure Requirements: Companies must disclose lease terms, discount rates, maturity analysis of lease liabilities, and expense impacts in financial statement notes.