A Note on Leases

Abstract

This technical note explains how to account for leases under Accounting Standards Codification 842. This new addition to US generally accepted accounting principles became effective for fiscal years beginning after December 15, 2019. The note provides broad treatment for how a lessee will account for a short-term, operating, and financing lease, and how a lessor will account for short-term and sales-type leases with and without manufacturing profit. The intent is to provide a brief overview of lease accounting. As such, it is most appropriate for MBA or finance students who need to understand the broad effects of leases on the balance sheet, income statement, and statement of cash flows. Excerpt UVA-C-2439 May 28, 2020 A Note on Leases Background As you may have seen from your own personal experience, leases are contracts where the lessee obtains the right to use an asset (such as an apartment, vehicle, or other) in exchange for a series of regular payments to the lessor. While common in practice, these arrangements have caused challenges for standard setters and analysts. The big question is who owns the asset after the arrangement—the lessee, the lessor, or both? In the past (generally fiscal years 2018 and prior), many firms that leased assets were able to structure the lease in a way that made it appear that they were borrowing the asset for a short term. Therefore, the balance sheet did not include the asset or corresponding liability for the lease payments. Firms were motivated to structure leases in this manner in order to appear less levered. They could simply renew the short-term lease and continue operating the asset over long horizons without ever recording the asset and liability on the balance sheet. . . .