Describe the various methodologies in accounting for leases

ACCOUNTING FOR LEASES

An alternative to borrowing cash to purchase buildings, equipment, and certain other assets is signing a contract to lease the property from its owner, called the lessor. Leases vary in their characteristics but all convey to the lessee the right to use an asset. In some cases the lessor enjoys the rewards and bears most of the risks of ownership, whereas in other cases the lessee, or user of the property, enjoys the rewards and bears most of these risks. U.S. GAAP and IFRS provide for two methods of accounting for long-term leases: the operating lease method and the capital or finance lease method. The operating lease method is appropriate when the lessor enjoys most of the rewards and bears most of the risks of ownership. The leased property is an asset on the books of the lessor. The capital lease method is appropriate when the lessee enjoys most of the rewards and bears most of the risks of ownership. The lessee records both the leased asset and a lease liability, much the same as if it had borrowed to purchase the asset. Capital leases are economically similar to purchasing assets with funds obtained from issuing long-term bonds and result in similar accounting.

OPERATING LEASE METHOD

In an operating lease, the owner, or lessor, enjoys the rewards and bears most of the risks of ownership. For example, if a lease requires the lessee to make fixed periodic payments, the lessor benefits from decreases in interest rates (the lessor receives the fixed periodic amount) but bears the risk of interest rate increases (the lessor cannot increase the fixed periodic payment). If the lease specifies that the lessee must return the leased asset to the lessor at the end of the lease term, the lessor must then release or sell the asset. The lessor bears the risk of technological change and other factors that would affect its ability to lease or sell the asset.

CAPITAL LEASE METHOD

In a capital lease, the lessee enjoys the rewards and bears most of the risks of ownership.
U.S. GAAP uses the term capital lease method and IFRS uses the term finance lease method. The treatment recognizes the signing of the lease as the simultaneous acquisition of a long-term asset and the incurring of a long-term liability for lease payments.

At hen of each year the capital lease method record recognizes that the lease payment both pays interest and reduces the lease liability. Separating the portion of the lease payment that represents interest from the portion reducing the liability follows the effective interest method.