Setting Expectations

Leasing is now a popular and widely accepted method of financing access to large capital assets, and although there is a wide variety of lease contracts accountants have historically always placed them under two categories.

1. Operating Leases

2. Finance leases (known as capital leases under some jurisdictions).

The essence of lease accounting both under UK GAAP and international GAAP is based on the principle of commercial substance prevailing over strict legal form. This is a double-edged sword as it ensures that legal dogma does not reduce the transparency of financial statements and yet simultaneously provides a potential opportunity for creative accounting in the guise of off-balance sheet finance.

An operating lease is the equivalent of a short-term rental whereby the bulk of the risks and rewards associated with ownership remain with the lessor. Hence substance and legal form are similar with the asset being recorded on the balance sheet of the lessor, whilst the lessee simply records an expense equivalent to the aggregate of the lease payments spread evenly over the lease term; hence cash flows and expenses may not be equal. It is this aspect that concerns many commentators on accounting as the absence of the asset and obligations contracted for future lease rentals lie outside the lessee's financial statements and are said to be off-balance sheet.

For a company that has net assets there are considerable attractions of off-balance sheet financing.