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 looks through the legal form, and is instead based upon the economic substance of the agreement.
For leases that are substantially equivalent to the purchase of an asset on credit, the lessee records the leased asset, usually within property, plant, and equipment. The asset is then depreciated over its useful life to the lessee. The lessee also records an offsetting liability reflecting the obligation to make continuing payments under the lease agreement. This liability is accounted for in similar fashion to a note payable, including an apportionment to interest expense. Such transactions are termed financing leases (or “finance leases”). Other leases are known as operating leases. If an operating lease is less than one year the rent is expensed as incurred. Longer-term operating leases result in the initial recording of a “right of use” asset, generally matched by a corresponding liability to make payments. Over time both the asset and liability are reduced while rent is paid and expensed, usually on a straight-line basis.
Why all the trouble over lease accounting? Think about an industry that relies heavily on financing 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.|
|Describe general principles of accounting for leases.|