How Do You Capitalize an Asset

Capitalizing an asset means recording it as a long-term investment on the balance sheet rather than treating it as an expense on the income statement. This applies to leased equipment, machinery, vehicles, or other assets that a company acquires under a capital lease (finance lease) instead of an operating lease.

When an asset is capitalized, its cost is spread out over time through depreciation rather than being deducted all at once as an expense.

How to Capitalize a Leased Asset

If equipment should be capitalized (as in a capital lease) but was incorrectly recorded as an operating lease, here’s how to adjust it:

✔ Step 1: Remove Lease Expense from Profit & Loss (P&L)

• In an operating lease, lease payments are recorded as monthly expenses on the income statement.

• Since a capital lease is treated as ownership, these lease payments should be eliminated from expenses.

✔ Step 2: Record the Asset on the Balance Sheet

• Add the leased equipment as a fixed asset (machinery, vehicles, etc.).

• Record the total present value of lease payments as the asset’s cost.

✔ Step 3: Record the Lease Liability

• A capital lease is like a loan—the company is financing the purchase over time.

• Record a lease liability equal to the total lease obligation.

✔ Step 4: Adjust for Depreciation and Interest

• Instead of a lease expense, report:

• Depreciation on the asset (spread over its useful life).

• Interest expense on the lease obligation.

• These two costs now replace the previous lease expense in the financial statements.

Example of Capitalizing a Lease

🔹 Incorrect (Operating Lease Treatment):

• $50,000 lease payments per year are recorded as an expense on the P&L.

• Net income is reduced by the full $50,000 each year.

🔹 Correct (Capital Lease Treatment):

• The leased equipment is capitalized at $200,000 on the balance sheet.

• Lease obligation of $200,000 is also recorded as a liability.

• Instead of a $50,000 lease expense, the business reports:

• $40,000 depreciation

• $10,000 interest expense

• EBITDA increases by $50,000 because lease payments are no longer an expense.

Why Capitalization Matters

✔ Makes the business more profitable – Removing lease expenses increases EBITDA, which is crucial for buyers evaluating “What is my business worth?”

✔ Improves financial transparency – Shows the true cost of asset ownership instead of inflating operating expenses.

✔ Helps buyers & lenders – Investors and lenders can better understand long-term asset investments.

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