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Assessing the Impact of the Right-of-Use Model
Under both U.S. GAAP and International Financial Reporting Standards (LFRS), there are two main classes of leases: operating and capital (referred to as a 'financing" lease in EFRS). Bom types of leases are executory contracts, meaning mat they represent signed contracts mat obligate the parties (lessor and lessee) to future performance (execution) under the terms of the contract Generally, executory contracts do not trigger a journal entry v^ien they are signed; only upon performance under the terms of the contract is it recognized in the financial statements. Capital leases represent an exception, however, because they are booked at inception of the lease.
Background
At the inception of a capital lease, the lessee records an asset and a liability (for the leased asset and the related financing obligation), and the lessor records a receivable and an offsetting reduction of the leased property. Subsequently, as rental payments are made to the lessor, the lessee reduces cash, recognizes interest expense, and amortizes the principal amount of the debt the lessee also depreciates the asset The lessor receives cash, recognizes interest income, and reduces the principal amount of the receivable.
With operating leases, the lessee shows neither the leased asset nor the related financing obligation. The lessor retains the leased asset on its books throughout the lease term, even though the lessee is the party using the asset. As such, operating leases are often called "off-balance sheet" leases. The lessee recognizes periodic rent expense over each period, and the lessor recognizes rent income.
Companies are required to provide note disclosures for operating leases in order to compensate for the lack of recognition in the financial statements. Under U.S. GAAP, lessees are required to disclose the yearly cash requirements under the terms of the lease for the ensuing five years, plus a lump sum for all amounts to be paid after five years. All cash payments disclosed in the notes are future values.
Over the years, entities have tended to structure most leases so mat they qualify as operating leases. In the United States, mis is achieved by avoiding four bright-line criteria that cause classification as a capital lease: 1) transfer of the ownership of the leased asset from the lessor to...