Lease Accounting: Substance vs. Form

Key Conceptual Issue

• Debate: Whether to treat leased equipment as an asset on the balance sheet (capitalization).
• Substance vs. Form:
  • Substance: We have the right to use the asset as if it were purchased.
  • Form: We do not have ownership of the leased equipment.
• General Consensus: Most accountants agree capitalization is correct, but methods vary.

Capitalization of Leases

• FASB Approach:
  • Capitalize all long-term leases (terms > 1 year) on the balance sheet as long-term assets.
  • Short-term leases (terms ≤ 1 year) are not capitalized.
• Lease Payments:
  • Considered future financial obligations.
  • Capitalization of lease payments means treating them as liabilities on the balance sheet.

Classification of Leases

• Types of Leases:
  • Finance Lease
  • Operating Lease
• Capitalization Requirement:
  • Both types require capitalization of assets and liabilities.

Finance Lease

• Expense Recognition:
  • Interest expense on lease liability using effective interest method.
  • Amortization expense on the asset on a straight-line basis.

Operating Lease

• Expense Recognition:
  • Interest expense measured using effective interest method.
  • Total lease expense remains constant per period, combining interest and amortization.
  • No separate recording of interest and amortization expenses.

Summary

• Finance Lease: Separate interest and amortization expenses.
• Operating Lease: Single lease expense, equal to sum of interest and amortization (calculated differently).
• Next Steps: Examples to be discussed in the following video.