A lessee obtains an asset's use while committing to payments, often without acquiring legal ownership of the underlying property. Under United States generally accepted accounting principles (U.S. GAAP), both finance and operating leases ordinarily create recognized assets and liabilities.
A lease conveys control over an identified asset's use for a period in exchange for consideration from the customer. The assessment depends on enforceable rights, including who benefits from the asset and who decides how it serves the business.
A lessee assesses the identified asset before recognizing lease-related assets and liabilities. The asset may be explicitly named or implicitly specified when made available; the following comparison assumes no substantive substitution right.
- A supplier's substitution right is substantive only when practical ability and economic benefit from substitution both exist throughout the relevant period.
- A right to replace equipment only for repairs does not, by itself, constitute a substantive substitution right.
- The customer must obtain substantially all economic benefits from use within the contract's scope, including relevant output and by-products.
Common mistakes
- Using undiscounted payments. Marlen's $119,790 future cash total produces a $99,300 liability; the $20,490 difference is future financing cost.
- Capitalizing negotiation costs. Adding Marlen's $900 legal fee incorrectly raises the initial asset from $102,900 to $103,800.
- Confusing asset and liability reduction. Marlen's first operating year reduces its asset by $31,200 and its liability by $30,000.
Bottom line
- A lease requires an identified asset and customer control over both economic benefits and the asset's use.
- Meeting any one finance criterion produces finance classification; an operating lease meets none, and 75% and 90% are reasonable benchmarks rather than universal mandatory thresholds.
- Measurement includes unpaid fixed and in-substance fixed payments, commencement-based indexed amounts and applicable option, penalty and probable guarantee payments.
- Residual guarantees can contribute different amounts to classification and liability measurement; the classification test avoids double counting included guarantee amounts.
Exam shortcut
Mark commencement and every payment date before using a PV factor. For beginning-of-period cash, remove the immediate payment from unpaid amounts before accruing interest. Build separate columns for classification payments, recognized liability and initial asset. Put a guarantee's full applicable amount in the classification column and its probable obligation in measurement. Label cash, interest or accretion, liability reduction and asset reduction separately.
The full lesson (about 8,199 words, 55 min read) adds 5 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- III.F1
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