This is another contentious area of financial reporting. For many years, if you leased an asset, you recorded as an expense your regular rental payments and that was the end of the matter. However, in the 1980s it was recognized that from an economic perspective, leasing was just another form of asset financing. In many cases you gained control over an asset and you had a very real legal liability to pay rentals for however many years to come. The argument was that if you were representing the economic substance in preference to the legal form, you should show both a tangible asset and a lease liability in your balance sheet.
IAS 17 Leases is a standard that takes this view, and is similar in thrust to the US standard, SFAS 13. IAS 17 introduced the concept of the finance lease and the operating lease. An arrangement was a finance lease if the terms of the lease transferred ‘substantially all the risks and rewards incidental to ownership’. In such a case you recognized the asset at inception of the lease, measured at the present value of the lease payments, using the discount rate inherent in the lease contract. You also recognize a lease liability for the same amount.
Subsequent to that, the asset is classified according to the nature of the physical asset and it is depreciated in the same way as other assets of the same class. The rental payment is split between interest on the outstanding liability and repayment of that liability.
IAS 17 and SFAS 13 set out to ...