Corporate Financial Reporting and Analysis, 3rd Edition

Chapter 11

Leases and Off-Balance-Sheet Debt

Introduction

In this chapter we address the accounting treatment for leases and off-balance-sheet debt. The discussion on leases is limited to the lessee’s perspective. Leasing is a critically important topic for the financial statement reader because in many industries it has become the most common form of asset financing. The economic rationale for such a large industry is complex, and beyond the scope of this book, but accounting practice has certainly played an important role in the pervasive use of leasing.

Capital vs. operating leases

A lease is an agreement between two parties for the rent of an asset. The lessor is the legal owner of the asset who rents out the asset to the lessee. At the end of the lease period the asset is usually returned to the lessor. The lessee pays a periodic (monthly, quarterly, yearly) rental fee to the lessor in return for use of the asset. The accounting treatment for the lease depends on the nature of the lease.

US GAAP and IFRS distinguish between two types of leases: capital and operating. In the case of the former, future lease payments are capitalized at an appropriate borrowing rate, with the present value appearing as both an asset and a liability on the balance sheet. Operating leases are treated as rental contracts, with the periodic lease payments recorded as operating expenses. The present value of the lease does not appear on the balance sheet as either an asset or liability. In fact, operating ...