The various views on capitalization of leases are as follows.
1. Do Not Capitalize Any Leased Assets. This view considers capitalization inappropriate, because you do not own the property. Furthermore, a lease is an “executory” contract requiring continuing performance by both parties. Because companies do not currently capitalize other executory contracts (such as purchase commitments and employment contracts), they should not capitalize leases either.
1. Do Not Capitalize Any Leased Assets. This view considers capitalization inappropriate, because you do not own the property. Furthermore, a lease is an “executory” contract requiring continuing performance by both parties. Because companies do not currently capitalize other executory contracts (such as purchase commitments and employment contracts), they should not capitalize leases either.
2. Capitalize Leases That Are Similar to Installment Purchases. This view holds that companies should report transactions in accordance with their economic substance. Therefore, if companies capitalize installment purchases, they should also capitalize leases that have similar characteristics. For example, Delta Airlines makes the same payments over a 10-year period for either a lease or an installment purchase. Lessees make rental payments, whereas owners make mortgage payments. Why should the financial statements not report these transactions in the same manner?
3. Capitalize All Long-Term Leases. This approach requires only the long-term right to use the property in order to capitalize. This property-rights approach capitalizes all long-term leases.
4. Capitalize Firm Leases Where the Penalty for Nonperformance Is Substantial.A final approach advocates capitalizing only “firm” (non-cancelable) contractual rights and obligations. “Firm” means that it is unlikely to avoid performance under the lease without a severe penalty.
In short, the various viewpoints range from no capitalization to capitalization of all leases. The FASB apparently agrees with the capitalization approach when the lease is similar to an installment purchase: It notes that Delta should capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is non-cancelable. Non-cancelable means that Delta can cancel the lease contract only upon the outcome of some remote contingency, or that the cancellation provisions and penalties of the contract are so costly to Delta that cancellation probably will not occur.
This viewpoint leads to three basic conclusions: (1) Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership. (2) The same characteristics should apply consistently to the lessee and the lessor. (3) Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases. Companies should not capitalize operating leases. Instead, companies should account for them as rental payments and receipts.