How do lessees account for leases?

For assets under operating leases, lessees recognize neither an asset nor a payment obligation on their balance sheet; instead, lease payments are recorded as expense when due.  Because of this, operating leases are considered off-balance sheet financing.

Both US GAAP and IFRS call for the capitalization of finance leases by the lessee.  If practical, the lessee should use the interest rate implicit in the lease as the discount rate in calculating the present value of the MLPs; if not, the lessee is to use its incremental borrowing rate – because the lessee will not know the lessor’s implicit rate, the lessee generally uses the incremental rate.

Lessees recognize finance leases at lease inception in their balance sheets as assets and liabilities at amounts equal to the fair value of the leased asset or, if lower, the present value of the minimum lease payments (MLPs).  When initial direct costs are added to the cost of the leased asset (capitalized), the value of the asset recorded by the lessee will be higher than the value of the related lease obligation.

The classification of a finance lease as a direct-financing or sales-type lease by lessors has no accounting implications for lessees.  Lessees depreciate the leased assets in a manner consistent with their normal depreciation policy for similar depreciable assets and allocate the MPLs between the repayment of the lease obligation and interest expense using the effective interest method to produce a constant periodic rate of interest on the lease obligation.

The lease payments reduce the leased asset’s carrying value and corresponding liability.  The lessee typically pays and records executory costs incurred in finance leases.  Where the lease term is shorter than the asset’s economic life, such as when the lessee has a bargain purchase option, the lessee depreciates the asset over its longer life.