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    A lease is a contract which grants one party (the lessee) the use of certain property, plant, equipment etc. for a specified period of time usually in exchange for periodic payments to the other party who actually owns the property (the lessor). The treatment of leases for accounting purposes is outlined in FASB Statement of Financial Accounting Standards No. 13 (published November 1976) as well as, today, in the accounting standards codification under section 840 (Leases). 


    From the perspective of the lessee, leases can be classified as either capital leases or operating leases. Leases that are classified as operating leases are disclosed in the notes to the financial statements, and a lease expense or rent expense is recognized on the income statement. When a lease is classified as an capital lease, the property underlying the lease is recognized as an asset (which is subsequently depreciated) and the present value of the lease payment obligations is recorded as a liability. 


    The asset should be recognized on the balance sheet at its fair value, and the present value of the lease payment obligations should be calculating using the implicit rate of interest in the lease (ie. the rate of interest that makes the present value of the lease payments equal to the fair value of the leased property). The lease payments used in this calculation should exclude executory costs, such as insurance, and those costs should be expensed each period when they are paid. 

    Recording Lease Payments 

    Because the lease payments are usually a fixed amount, they will have a interest portion and a principal portion, similar to mortgages. The interest expense calculation should use the same rate of interest that was used to discount the lease payments to present value. See mortgages which shows how to calculate and record payments with an interest and principal component. 

    Criteria for Classifying a Lease as a Capital Lease

    US GAAP requires that at least one of four criteria be met for a lease to be classified as an operating lease:
    (i) There is a transfer of ownership from the lessor to the lessee of the asset at the end of the lease term. 
    (ii) The lease contains a bargain purchase option.
    (iii) The lease term is equal to 75 percent or more of the estimated useful life of the leased property. 
    (iv) The present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property to the lessor. The minimum lease payments used in this calculation should exclude the portion of payments that represent executory costs such as insurance. The fair value calculation for the property should exclude the value of related investment tax credits,

    Note: From the perspective of the lessor, a lease may be classified as (i) sales-type leases, (ii) direct financing leases, (iii) leveraged leases, and (iv) operating leases. Leases represent investment assets to the lessor, rather than a liability. 

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