What does it mean to capitalize an operating lease?

Capitalizing an Operating Lease: Deconstructing a Financial Myth (And Why It Doesn’t Happen)

The phrase “capitalizing an operating lease” might sound like standard accounting jargon, but it’s actually a bit of a misnomer. Under Generally Accepted Accounting Principles (GAAP), and even with the evolving landscape under IFRS (International Financial Reporting Standards), the core concept remains: you don’t actually “capitalize” an operating lease in the traditional sense before the ASC 842 (Topic 842).

To understand why, let’s break down the fundamentals. Operating leases, under older GAAP and to some extent even now, are essentially treated as rental agreements. Think of renting an office space or a piece of equipment for a specific period. You’re using the asset, but you don’t own it.

The key difference lies in how these leases are handled compared to capital leases (now largely replaced by finance leases under IFRS 16 and ASC 842). Capital leases, on the other hand, are treated as if you did purchase the asset. This means they significantly impact the balance sheet. A capital lease results in:

• Asset Recognition: The leased asset is recorded on the balance sheet.
• Liability Recognition: A corresponding lease liability is also recorded.
• Depreciation: The asset is depreciated over its useful life (or the lease term, if shorter).
• Interest Expense: Interest expense is recognized over the lease term, reflecting the financing component.

The Operating Lease Story: Off-Balance Sheet Treatment

Historically, operating leases have been treated quite differently. The crux of their “off-balance sheet” treatment lies in the following:

• No Asset or Liability Recognition (Before ASC 842): Before the introduction of Topic 842, you didn’t record the leased asset or a corresponding liability on the balance sheet. This meant companies could effectively “hide” substantial obligations, making their financial picture appear healthier than it actually was.
• Rental Expense Recognition: Instead of depreciation and interest, you simply recorded rental expense on the income statement each period the lease was active. The expense was recognized generally on a straight-line basis over the lease term.

So, Why the Confusion?

The phrase “capitalizing an operating lease” might arise when discussing the impact of new lease accounting standards, particularly ASC 842 and IFRS 16. While the direct capitalization as described above isn’t happening with older GAAP, these new standards do bring operating leases “onto” the balance sheet.

Under ASC 842/IFRS 16:

• Right-of-Use (ROU) Asset: A “right-of-use” asset is recognized, representing the lessee’s right to use the underlying asset for the lease term.
• Lease Liability: A lease liability is also recognized, representing the lessee’s obligation to make lease payments.

This doesn’t mean the lease is now treated exactly like a capital lease. There are still key differences in how expenses are recognized. For example, operating lease expenses are usually recognized as a single “lease expense” on the income statement.

In Conclusion:

While you wouldn’t traditionally “capitalize” an operating lease under older GAAP, the introduction of new lease accounting standards significantly alters the landscape. The new standards don’t necessarily capitalize the lease in the same way a capital lease was, but they do require the recognition of assets and liabilities related to operating leases on the balance sheet, improving transparency and providing a more accurate picture of a company’s financial obligations. Therefore, while the phrase might be inaccurate in its literal sense, it’s a shorthand way of describing the impact of these new standards in bringing operating leases more prominently into the financial reporting picture.