Capitalising Costs and Capital Leases

CFA Level II
#1

When you capitalise costs, Net Income (NI) is Higher in the initial years but Lower in the later years.

But, from a Lessee’s POV, for a Capital/Finance Lease, NI is Lower in the initial years and Higher in the later years.

Can someone explain why this is so? I’d think, both being assets, their impact on NI would be the same.

#2

I think total income is the same over the course of the lease, but for capital lease lessor reports higher income in the beginning as you have higher lease receivables * same interest rate while for operating lease lessor report lower income = same rental income - higher depreciation costs in initial years, no?

#3

You’re mixing it up : Capital Lease results in Interest on Lease Liability + Depn Expense, while Operating Lease results in Lease Expense …

Did a bit more thinking and I think this is why NI is lower in the early years for Capital Lease as compared to Operating Lease.

NI is higher in the later years because the lease liability reduces due to excess payments over the required interest expense, which reduces interest expense in the later years.

If my understanding is wrong, feel free to let me know.

#4

We are talking about Lessor right?..I thought lessor remove the asset from BS once they lease it to the lessee under capital lease, no? If so, how can they depreciate something they don’t own?

#5

Ah sorry my bad, it appears I was more confused than you … i meant lessee in my original post

Edited my original post.

#6
  1. When you capitalise INTEREST expense, you AVOID them being charged to the IS as it would have been if you expense it, thus NI is higher when capitalising interest.

You delay the charges to the future when capitalising, but total charges are the same in either method.

  1. When you capitalise operating LEASES, you add the operating lease back into the your BS and you hit your IS TWICE: (a) on asset side, higher depreciation costs due to larger asset base depending on your depreciation method (b) on liabilities side, you need to service higher interest costs due to higher liability obligation.

Anyhow, the total costs are the same over the course of the lease in either method, you accelerate the charges to the IS now and suffer first, thus NI is lower now and higher in the future under capitalsing leases.