Capital Lease

So if a company decides to use a capital lease instead of an operating lease, what entries go onto the balance sheet? Lets say the asset is 10k and depreciates at a rate of 1k per year for 10 years? I assume Year 1 would be: Asset: +10k Liability: +10k Is this incorrect?

PV of cashflows is the basis Liability - annual payments are then split b/w interest (rate x closing b/s balance) and principal repayments (diff b/w annual payment and calculated i component above) Asset - depreciated according to whatever is the policy - ie straight line…

okay, that’s what I figured. I am looking at this practice question and the answer seems to state otherwise: For purposes of analysis, interest capitalization by a growing firm is most likely to result in which of the following effects: D/E Ratio Interest Coverage Ratio A. Overstated Overstated B. Overstated Understated C. Understated Overstated D. Undetstated Understated The answer is C, with the explaination "Interest capitalization by a growing firm will lead to higher assets and equity, lower interest expense and higher net income. This will cause the debt-to-equity ratio to be understated and the interest coverage ratio to be overstated. Why is equity affected?

Interest Capitalisation will cause an increase in Asset and an equal amount of increase in Equity therefore, as E increases --> D/E goes down --> understated Also when we capitalize interest, It is stored in the balance sheet instead of hitting the Income Statement directly and reducing the income expense and hence increasing the EBIT EBIT increases and IE goes down --> therefore EBIT/IE goes high —> overstated Answer is C - Dinesh S

okay, so if I’m understanding this right when capitalizing a lease the areas on the balance sheet that are affected are Assets and Equity, Liabilities are unchaged. Would this be correct?

I think you are confusing Interest Capitalization with Lease Capitalization… The quaestion talks about ‘Interest Capitalization’ - Dinesh S

agreed, def separate issues - lease interest payments are expensed and not capitalised

> I assume Year 1 would be: > Asset: +10k > Liability: +10k What about Current and total liabilities? The lease payment which is paid within one year is current, the rest long term? It is important for CA/CL. thanks. Current assets are unchanged or?

yeh you’re confusing the two… im always doing it aswell… pretty much, to capitalise a lease, Assets/Liabs increase to capitalise interest, Assets/Equtiy increase although, can someone explain what the Equity entry is when capitalising interest??

i dint think there was an enrty for E i just look at it as since we cap the interest it does not hit the income statement… thus NI up… thus E up

ahhh good point… will remember that one =)