Plane imageMany 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 generally exceeding one year the applicable accounting rules dictate that the lessee account for a leased asset as though it has been purchased. The lessee records the leased right 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 financing 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). Short-term leases are known as operating lease. Rent is simply recorded as rent expense as incurred and the underlying asset is not reported on the books of the lessee.

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.
Describe general principles of accounting for leases.