Adjustments made for Capitalized Leases

I’m working through some of the EOC questions for FRA and one of the questions deals with making adjustments for capitalizing a lease (i.e. - we had the lease as an operating lease and want to see the effects of capitalizing)

In one of the questions we’re asked to address the change on our Leverage Ratio and the answers ends up stating: "The capitalized value of the leases is added to assets and liabilities but does not impact equity."

But I was under the impression the Equity would actually change a tiny bit…? Under a capital lease wouldn’t we have lower EBT (in the early years) and thus lower taxes, impacting cash which would in turn increase our equity? Maybe I’m not fully understanding

Could anyone shed some light?

The balance sheet is as of the end of a financial period. When we adjust the liability by capitalizing operating leases, we want to examine the TRUE liabilities of the company so only the expected operating lease payments in the future are relevant (the payments in the past, including the one in this period P/L statement are not relevant because YES, they are no longer liabilities if they were paid!).

So A - L = E, A and L increase by the same amount, Equity does not change.

Okay, but I guess that’s just my point… Do Assets and Liabilities really increase by the same amount? Sure we increase both the Assets and Liabilities by the same amount when adding in the lease obligation I agree with you there… but shouldn’t we have an increase in our cash account?

By capitalizing the lease, we should have lower taxable income (in the early years) and eventually pay less taxes which means we have higher cash. Higher cash = Higher Equity.

Perhaps I’m just not understanding your answer

Hehe let me try again.

All of the things you said is not the answer to this question. What you said is true if the question is asking for a comparison between 2 companies: one treat the lease as operating and the other treat the lease as finance.

This question is asking what happen to the ratio after the BS adjustment.

The point of doing adjustment here is to capitalize expected lease payments IN THE FUTURE. If everything is in the future how is it going to affect our cash flows in the current period?

As I mentioned earlier, the purpose of capitalizing operating lease is to show a truer Balance Sheet from the point of view of the analyst. We dont care about the payments already made because they are no longer liabilities.

So if I’m understanding you correctly, these are two seperate thoughts…

  1. If we compare two companies with (a) using capital leases and (b) using operating leases then yes we would see a difference in equity between the two due to taxes paid


  1. If we are simply making adjustments to the balance sheet at the end of the period then these taxes, libailities, etc, have all been settled and we are simply just taking the off balance sheet items and including them within our BS. Thus, we do not need to account for the addtional tax savings, etc.

Sound about right?

I believe that what they’re saying is that equity is not affected initially when the lease is capitalized.

Certainly equity will be diffferent during the life of the lease, but at the start (and, for that matter, at the end), it will be the same as it would be under an operating lease.

Cool, thanks. I would hate to get something wrong on the exam by screwing up such a detail like that

My pleasure.

@Mosstastic: You got the idea !

@S2000magician: As to the matter of comparing Operating Lease and Finance Lease, I think in the early years net income will be lower under Finance Lease because Depreciation from leased asset + Interest expense would be greater than the lease payment, thus Equity would be lower. Am I correct?


It’s also important to note that cash flows will higher for the financial lease in the earlier years because of tax savings on interest, but total cash flow will be the same under either by the end.

CFO (excluding the tax effect) will be higher, while CFF will always be lower because of prinicipal payment. Total cash flows will be the same throughout (no tax effect).