Impact of capital leases on financial statements

Balance sheet
At the inception:
· Create an leasehold asset and leasehold liability equal to the PV of lease payments discounted using lower of the lessor’s implicit rate and the lessee’s marginal borrowing rate.

Going forward:
· the leased asset is depreciated with the lessee's usual policy for depreciating its operational assets over the term of the lease (most common), or over the asset's useful life if ownership transfers or a bargain purchase option is present.

Income statement
Lease payments are split into two parts:

1) interest expense
· included in the income statement but is not part of operating income (earnings before taxes from continuing operations)

Interest expense = leashold liability x discount rate

2) Principal repayment
· included in the income statement and operating income.

Difference between lease payment and interest expense = principle repayment

Note:
· The interest portion will be higher in the first few years of the lease.
· Total income over the life of the leased assets will be the same for operating lease and capital leases.

Cash flow statement
· Interest expense included in cash flow from opeartions (CFO)
· Principal repayment included in cash flow from financing activities (CFF)
· Depreciation included in CFO

Note:
· CFO includes only the interest portion of the capital-lease expense and thus is overstated.
· The principal repayment is included as a cash outflow from CFF and thus understates CFF.
· Total cash flow statements remain unaffected by operating and capital leases.