How do you capitalize an operating lease and what changes on the financial statements?

Under the current standards (IFRS 16 effective 2019, ASC 842 effective 2019-2022), lessees recognize almost all leases on the balance sheet. However, CFA Level I still tests your ability to understand the mechanics and ratio impacts.

The Capitalization Mechanics:

When a lease is capitalized, the lessee records:

• A Right-of-Use (ROU) asset — the present value of future lease payments
• A Lease liability — same present value

Example: Crestwood Retail signs a 5-year lease for store space at $60,000/year, paid at year-end. The discount rate is 6%.

PV of lease payments = $60,000 x [(1 - (1.06)^-5) / 0.06] = $60,000 x 4.2124 = $252,742

At inception:

• ROU Asset: $252,742
• Lease Liability: $252,742

Year 1 Income Statement (IFRS 16):

• Depreciation of ROU asset: $252,742 / 5 = $50,549
• Interest on lease liability: $252,742 x 6% = $15,165
• Total expense: $65,714

Compare with the old operating lease treatment: rent expense would have been a flat $60,000. So IFRS 16 produces higher total expense in early years and lower in later years.

Year 1 Balance Sheet:

• Lease liability reduces by principal repayment: $60,000 payment - $15,165 interest = $44,835 principal
• Ending liability: $252,742 - $44,835 = $207,907
• ROU asset after depreciation: $252,742 - $50,549 = $202,193

Ratio Impacts:

IFRS vs US GAAP Difference: Under IFRS 16, ALL leases use the finance lease model (depreciation + interest). Under ASC 842, operating leases still show a single straight-line lease expense on the income statement, even though the asset and liability appear on the balance sheet.

Explore lease capitalization practice problems in our CFA Level I question bank.