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:
Capital Lease Obligation = Present Value of Future 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.