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ACCOUNTING FOR THE SUBSTANCE OF LEASES INTRODUCTION Leases have been the subject of numerous accounting standards. In 1949, the Committee on Accounting Procedure (CAP) issued Accounting Research Bulletin (ARB) No. 38. The Accounting Principles Board (APB) issued Opinions 5 and 7 in 1964 and 1966 respectively, and the Financial Accounting Standards Board (FASB) issued Statement No. 13 in 1976. The FASB Statement No. 13 was followed by about 23 amendments and interpretations. The FASB has issued more statements concerning leasing than any other topic. The number of amendments and interpretations concerning SFAS No. 13 illustrates that accounting for leases continues to be a controversial issue. Lease accounting has focused on determining the substance of the transaction rather than the legal form. Prior to ARB No. 38, the operating method was used to account for virtually all leases. When using the operating method, rental payments made by the lessee are recorded as rent expense, and lease payments received by the lessor are recorded as rent revenue. ARB No. 38 gave official recognition to the idea that some leases are the equivalent of installment purchases with debt financing. The focus of accounting standards has been on defining those situations in which (1) a lessee should account for a lease as a purchase with debt financing, and (2) a lessor should account for the lease as a loan to the lessee. Currently, these types of leases are called “capital” leases by the lessee and “direct financing” or “sales-type financing” leases by the lessor. All other leases are accounted for as operating leases. Under current Generally Acceptable Accounting Principles (GAAP), a lessee must account for a lease as either (1) a rental agreement (operating lease) or (2) a purchase with debt financing (capital lease). Accounting for both lessee and lessor is discussed in this paper; however, the primary focuses is on the lessee because of the strong resistance of many lessees to use of the capitalization (capital lease) method. Many lessees believe there is an advantage in reporting leases using the operating method because of the off-balance- sheet financing. If assets and liabilities are created by lease arrangements and are not reported on the balance sheet, assets and liabilities are understated, debt ratios are inaccurate; and if a profit is reported, the return on investment (ROI) is overstated. Therefore, there is substantial incentive for management to try to circumvent the lease capitalization criteria of accounting standards. On the other hand, users of financial statements are generally of the opinion that all material rights to the use of assets and the obligations to pay for those rights should be included on the face of the balance sheet. REVIEW OF RELATED LITERATURE
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