Capitalized Lease Method

An accounting approach that identifies a company's lease obligation as an asset on its balance sheet. This is done because although the company has not taken ownership of the asset, the transaction is still considered to be a beneficial economic exchange for the lease holder. Under this method, the expenses are higher in the early years and gradually decline over the term of the lease.

For example, assume that a company has a lease obligation of $500,000 for 10 years, with an interest rate of 10%. The company must make 10 payments of $81,372.70. These payments are comprised of both the interest payments and the principal payments. The interest payments are 10% of the lease balance. For example, the first interest expense is $50,000 ($500,000 x .10). The yearly payment less the interest expense is the principal payment, which reduces the lease balance. The lease is also amortized according to the company's respective amortization schedule. Assuming a straight-line schedule, the yearly amortization will be $50,000 ($500,000/10 years). Finally, the total annual capital lease expense that is realized by the company is equal to the interest expense plus the amortization, which is $100,000 ($50,000 + $50,000) for the first year. This annual expense will continue to decrease over the life of the lease.