For a capital lease, which statement describes the initial accounting and subsequent periods?

For a capital lease, which statement describes the initial accounting and subsequent periods?

• A. I/S: depreciation is recorded immediately; B/S: asset increases; CFS: CFO increases.
• B. I/S: no change initially; B/S: asset and liability increase by the PV of payments; CFS: no change initially.
• C. I/S: no change initially; B/S: asset and liability increase by PV; CFS: no change initially; later, depreciation and interest reduce NI and CFO is affected by interest payments with depreciation added back.
• D. I/S: rent expense recognized upfront; B/S: no change; CFS: CFO decreases.

Answer: (C)

The idea being tested is how a capital (finance) lease is reflected in financial statements over time. When a lease is treated as a capital lease, you set up both an asset and a liability on the balance sheet at the present value of the lease payments right at inception. There isn’t a rent expense recognized right away on the income statement because the cost is financed—instead, the period’s expenses come from depreciation on the leased asset and interest on the lease liability in subsequent periods. So, in the initial moment you don’t record income statement activity for the lease, and the balance sheet shows an asset and a corresponding liability increased by the present value of the payments. The cash flow statement typically shows no immediate cash flow at inception for the lease. Later, as time passes, you recognize depreciation on the asset and interest on the lease liability, which both reduce net income. In the cash flow statement, the principal portion of lease payments is a financing cash outflow, while the interest portion is an operating cash outflow; when using the indirect method, the non-cash depreciation is added back to net income in computing cash flow from operations, so the period’s cash flow from operations is affected by the interest payments, with depreciation treated as a non-cash adjustment. That alignment is why this description fits a capital lease: no initial I/S impact, assets and liabilities rise by the PV of payments, no initial CFS impact, and later periods show depreciation and interest affecting NI, with CFO reflecting the interest outflow and depreciation being added back in the indirect computation.

The idea being tested is how a capital (finance) lease is reflected in financial statements over time. When a lease is treated as a capital lease, you set up both an asset and a liability on the balance sheet at the present value of the lease payments right at inception. There isn’t a rent expense recognized right away on the income statement because the cost is financed—instead, the period’s expenses come from depreciation on the leased asset and interest on the lease liability in subsequent periods.

So, in the initial moment you don’t record income statement activity for the lease, and the balance sheet shows an asset and a corresponding liability increased by the present value of the payments. The cash flow statement typically shows no immediate cash flow at inception for the lease. Later, as time passes, you recognize depreciation on the asset and interest on the lease liability, which both reduce net income. In the cash flow statement, the principal portion of lease payments is a financing cash outflow, while the interest portion is an operating cash outflow; when using the indirect method, the non-cash depreciation is added back to net income in computing cash flow from operations, so the period’s cash flow from operations is affected by the interest payments, with depreciation treated as a non-cash adjustment.

That alignment is why this description fits a capital lease: no initial I/S impact, assets and liabilities rise by the PV of payments, no initial CFS impact, and later periods show depreciation and interest affecting NI, with CFO reflecting the interest outflow and depreciation being added back in the indirect computation.