Do Capital Lease Payments Flow Through the Income Statement?

by John Cromwell

Reporting the effects of capital leases can be complicated regardless of whether you are renting out or using rented property. In either scenario, entering into the agreement will not affect the income statement initially. Either an anticipated income or expense item will be recorded. When the rent payments begin, both the lessor and lessee will have to include the transactions on their income statement.

GAAP Basics

In the United States, financial reporting requirements are defined by a series of standards known as the generally accepted accounting principles. GAAP is composed of a series of statements detailing how financial events should be reported. With regards to reporting capital lease activity, the appropriate report to reference is the Statement of Financial Accounting Standards No. 13.

Capital Lease Defined

A capital lease under GAAP is defined in terms of the lessee’s rights to the rented property. A capital lease exists in one of four circumstances. The first is if the property automatically transfers to the lessee at the end of the lease term. Second, is if the lessee can purchase the property at a significant discount after the term. The third circumstance is when the term of the lease is for at least 75 percent of the estimated economic life of the asset. The final situation is when the present value of the rent payments equal or exceeds 90 percent of the value of the underlying property.

Capital Lease Payments -- Lessees

The lessee will record an asset representing the rental property and a liability representing the lease payment owed at the outset of the lease. The asset and liability will be valued at the present value of the minimum lease payments. This initial entry will only affect the balance sheet. If the asset will be owned outright or is subject to a bargain acquisition price at the end of the lease term, the asset can be depreciated normally. If the asset does not meet any of these criteria, it can still be depreciated, but the useful life will be defined by the term of the lease. When the lease begins, the rent payments are divided into two parts. A large portion of the payment will be used to decrease the lease liability, with the remainder being recorded as interest expense. Both the depreciation and interest expenses flow through the income statement.

Capital Lease -- Lessors

Lessors do not identify leases as capital for their purposes but either as sales or direct financing leases. In both of these types of leases, the underlying rental agreement transfers or grants the right of transfer of the rental property to the lessee. As the definition of a capital lease is the effective transfer of the rental property to the lessee, both the sales and direct financing leases are the lessor equivalent.

Lessors Recording Capital Leases

At the outset of the lease, regardless of type, the lessor will record an asset of “minimum lease payments receivable,” which will equal the present value of the rent payments due per the lease. The lessor will then zero out the value of the rented asset since it was effectively transferred to the lessee. The difference between the value of the minimum lease payments and the carrying value of the rental property is unearned income, which is a liability. Recording the initial part of the transaction will not flow through the income statement but only on the balance sheet. As the lease payments are made, unearned income will shift into earned income at a constant rate based on the term of the lease. As the income is earned, it will flow through the income statement.


When preparing financial statements and tax returns, consult with a certified public accountant. This article does not provide legal advice; it is for educational purposes only. Use of this article does not create an attorney-client relationship.

About the Author

John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.

Photo Credits

  • Hemera Technologies/ Images
Suggest an Article Correction