Explain the accounting for leases

Answer 1

LEASES

Firms account for leases using either the operating lease method or the capital (finance) lease
method. The operating lease method treats leases as executory contracts, with neither the
leased asset nor the lease liability recognized on the lessee's balance sheet. The lessor and lessee recognize rent revenue and rent expense respectively as the lessee uses the leased asset over time.

The capital, or finance, lease method treats leases equivalent to installment purchases or sales, where the lessee borrows funds from the lessor to purchase the asset and the lessor recognizes profit at the time of sale. The lessee records the leased asset and the lease liability on the balance sheet at the present value of the contractual cash flows at the time of signing the lease. The lessee amortizes the leased asset, similar to recognizing depreciation on buildings and equipment. The lessee recognizes interest expense on the lease liability, similar to recognizing interest expense on long-term notes or bonds. The lessor records the signing of a capital lease the same as if the lessor sold the leased asset for an installment note receivable. The lessor records the lease receivable at the present value of the contractual cash flows, removes the cost of the leased asset from its accounting records, and recognizes income for the difference. Over time, the lessor recognizes interest revenue in amounts paralleling interest expense recognized by the lessee (borrower).

U.S. GAAP and IFRS provide criteria for distinguishing operating leases from capital
leases. The criteria attempt to identify the entity, whether lessor or lessee, that enjoys the benefits and incurs the risk of the leased asset. When the lessor enjoys the benefits and bears the risk, the lease is an operating lease. When the lessee enjoys the benefits and bears the risk, the lease is a capital lease. U.S. GAAP provides four criteria, any one of which qualifies a lease as a capital lease. IFRS provides more general criteria for identifying the entity enjoying the rewards and incurring the risk. Firms cannot currently apply the fair value option to capital leases.

The FASB and the IASB have undertaken a joint project involving the lessee's accounting for leases. The accounting for operating leases may change in the future in light of deliberations of standard-setting bodies regarding the definition of an asset and a liability. The emphasis on a present economic benefit for an asset and a present obligation for a liability, as opposed to a past transaction for an asset and past benefits received for a liability, may have the result of treating all leases as capital leases.