A company previously classified a long-term equipment lease as an operating lease and expensed the lease payments as rent expense. Under the current lease accounting standard, the lessee must capitalize this lease by recognizing a right-of-use asset and a corresponding lease liability on the balance sheet. Holding all else constant, this capitalization will most likely:
- Adecrease total assets and total liabilities, improving the current ratio
- Bhave no effect on the balance sheet but increase net income
- Cincrease equity while leaving total assets and liabilities unchanged
- Dincrease total assets and total liabilities, increasing the debt-to-assets ratio and decreasing asset turnover
Show answer & explanationAnswer & explanation
Correct answer: D. increase total assets and total liabilities, increasing the debt-to-assets ratio and decreasing asset turnover
Capitalizing a lease adds a right-of-use asset and a lease liability of equal initial amount to the balance sheet, increasing both total assets and total liabilities. This raises the debt-to-assets (leverage) ratio and reduces asset turnover (revenue/total assets) because total assets rise without a corresponding increase in revenue.
Why the other options are wrong
- A. Capitalization increases, not decreases, both assets and liabilities.
- B. The balance sheet is directly affected since new asset and liability accounts are created.
- C. Equity is not directly increased by lease capitalization; assets and liabilities both rise instead.
Lease Capitalization Effect on Ratios
Capitalizing a lease (recognizing a right-of-use asset and lease liability) increases both total assets and total liabilities, which raises leverage ratios and lowers asset turnover and return on assets, compared to expensing lease payments as incurred.
- Right-of-use asset and lease liability recognized at present value of payments
- Increases total assets and total liabilities symmetrically at inception
- Raises debt-to-equity and debt-to-assets; lowers asset turnover and ROA
Memory trick: Capitalize the lease, both sides of the scale grow heavier.