Many businesses acquire needed assets via a lease arrangement. With a lease arrangement, the lessee pays money to the lessor for the right to use an asset for a stated period of time. In a strict legal context, the lessor remains the owner of the property. However, the accounting for such transactions focuses through the legal form, and is instead based upon the economic substance of the agreement.

If a lease effectively transfers the “risks and rewards” of ownership to the lessee, then the applicable accounting rules dictate that the lessee account for the leased asset as though it has been purchased. The lessee records the leased asset as an item of property, plant, and equipment, which is then depreciated over its useful life to the lessee. The lessee must also record a liability reflecting the obligation to make continuing payments under the lease agreement, similar to the accounting for a note payable. Such transactions are termed capital leases. Note that the basic accounting outcome is as though the lease agreement represents the purchase of an asset, with a corresponding obligation to pay it off over time (the same basic approach as if the asset were purchased on credit).

Of course, not all leases effectively transfer the risks and rewards of ownership to the lessee. In the U.S., the determination of risk/reward transfer is based upon evaluation of very specific criteria: (1) ownership transfer of the asset by the end of the lease term, (2) minimum lease payments with a discounted present value that is 90% or more of the fair value of the asset, (3) a lease term that is at least 75% of the life of the asset, or (4) some bargain purchase element that kicks in before the end of the lease. If a lease does not include at least one of the preceding conditions, it is not a capital lease. Instead, it is an operating lease. Rent is simply recorded as rent expense as incurred and the underlying asset is not reported on the books of the lessee. Under international accounting standards, lease accounting rules are not as specific in guidance, but are substantively similar in intent and outcome.

Why all the trouble over lease accounting? Think about an industry that relies heavily on capital lease agreements, like the commercial airlines. One can see the importance of reporting the aircraft and the fixed commitment to pay for them. To exclude them from the financial statements would fail to represent the true nature of the business operation.


Did you learn?
Who is a lessee, and who is a lessor?
Cite some possible advantages of a lease.
Distinguish between an operating lease and a capital lease.
Describe general principles of accounting for an operating lease?
Describe general principles of accounting for a capital lease?