Topic: Current accounting for leases requires that certain leases be capitalized
ID: 2549243 • Letter: T
Question
Topic: Current accounting for leases requires that certain leases be capitalized. For capital leases, an asset and the associated liability are recorded. Whether or not the lease is capitalized, the cash fows are the same. The rental payments are set by contract and are paid over time at equally spaced intervals. Required: If one of the objectives of fnancial reporting is to enable investors, creditors, and other users to project future cash fows, what difference does it make whether we report the lease as a liability or simply describe its terms in foot-notes? Discuss. Journal Article Review: In addition, read journal article: Assessing the Allowance for Doubtful Accounts by MARK E. RILEY (Journal of Accountancy) found at: http://www.journalofaccountancy.com/ssues/2009/Sep/20091539 and submit one page review on BlackboardExplanation / Answer
“Lease” contracts can be segregated into two types; “Operating lease” & “Capital lease”. The basic difference between these two is ownership of the asset being leased. In an “Operating lease”, the ownership of the asset remains with the lessor, whereas in “Capital lease”, the ownership may get changed depending upon the terms of lease contract. There are many advantages and disadvantages of both the type, which is directly related to cash-flows. Therefore, there exist different regulatory guidelines in terms of reporting of both the leases as they have substantial impact on the financial statements.
Arguably the most attractive advantage of operating leases is that they can be used as a form of off-balance sheet financing. However, this causes much confusion. When a company acquires an asset with debt financing, a liability shows up in its financial statements alerting investors of the claims against future income. When an asset is leased, however, no liability is created even though the company has entered into a lease contract and is legally obligated to make lease payments in the future. It is no surprise then that many experts think operating leases should be classified as a liability. Steve C Lim (2003), from The University of Texas’ accounting department says, “Ratings agencies and finance textbooks agree that long-term lease obligations represent debt, regardless of the accounting treatment” (p. 3). Current FASB standards require that operating leases be disclosed in financial statements. Judging from notes alone it can be laborious to accurately estimate operating lease obligations, according to Amy Feldman (2002) writing for Money.
In some industries operating leases make up the bulk of financing arrangements. Feldman notes (2002), “Operating leases are popular in industries that use expensive equipment” (p. 46). The airline industry is a perfect example. Feldman (2002) goes on to say that AMR, the parent company of American Airlines, leases 362 planes. Of these, 240 or roughly two -thirds, are under operating leases. If such leases were accounted for as debt, it would drastically alter AMR's financial appearance.
Operating leases are not always abused. Many times they are truly the simple rental agreements that they're packaged as. FASB has also created guidelines for what constitutes an operating lease. If these requirements are not met, a capital lease is used. Capital leases do not keep anything off the balance sheet.
The other classification of a lease in the business world today is a capital lease, sometimes referred to as a finance lease (Spiceland, Sepe, Nelson, Tomassini, 2009).
One of the fundamental ways companies obtain expensive equipment in the business world today is through capital or finance leases. Capital leases sometimes allow companies to be able to use and eventually own equipment and material that they would not otherwise have the funds to purchase completely up front. FASB has laid out four criteria that a lease must meet in order to be classified as a capital lease. The lease only needs to meet one of these four criteria in order to be classified as a capital lease.
The first criteria that a lease must meet in order to be classified as a capital lease is that “the agreement must specify that ownership of the asset transfers to the lessee” (Spiceland, Sepe, Nelson, Tomassini, 2009, p. 760). When ownership is transferred, the lessee then has full control of that asset. Before the ownership has been transferred, the lessor maintains all the risks of owning that asset. This is a fairly simple requirement to meet and understand. “The agreement must contain a bargain purchase option” to be considered a capital lease (Spiceland, Sepe, Nelson, Tomassini, 2009, p. 760). This criterion gives the option for the lessee to purchase the asset at a lower price during the lease if they choose to do so. If a lessee was going to make payments on an asset and then still be required to pay full price for that same asset, neither party could record the previous transactions as a capital lease.
The third criteria that FASB set for a lease to be classified as a capital lease is that, “the non-cancelable lease term is equal to 75% or more of the expected economic life of the asset” (Spiceland, Sepe, Nelson, Tomassini, 2009, p. 760). This number of 75% is admittedly somewhat of an arbitrary number. But FASB set this number along with the fourth criteria that is, “the present value of the minimum lease payment is equal to or greater than 90% of the fair value of the asset” (Spiceland, Sepe, Nelson, Tomassini, 2009, p. 760). This last criterion is the one that people have trouble avoiding if they are trying not to write a capital lease and keep the lease off the balance sheet.
Capital leases make the company’s balance sheet have more liability as opposed to an operating lease. Because of the lower liability the company has if it makes an operating lease, Teh Hooi Ling (2005) of The Business Time Journal Singapore states that, “operating leases may indicate a higher efficiency in terms of asset turnover and return on assets” (p. 13). By committing to a non-cancelable capital lease, a company automatically increases their liability. Investors will look at the asset turnover and see that it is less efficient when a company has a capital lease than if it were to have an operating lease. In reality, the company may actually be better off reporting the lease as a capital lease because, “the total expense of a capital lease would be lower and fall below that of an operating lease as the interest charges declined following the repayment of the lease liability” (Ling, p. 13). So if a company reports their lease as an operating lease it may have a lower liability, but it will increase their expenses.
Reference
Edward Nusbaum. (2007, March). Lease accounting rules need to be changed. Accounting Today, 21(5), 6, and 8. Retrieved January 28, 2011, from Accounting & Tax Periodicals.
Feldman, Amy. (2002, April) Off balance. Money, 31(4), 46-47. Retrieved January 24, 2011, from Accounting & Tax Periodicals.
Lim, Steve C., Mann, Steven C. and Mihov, Vassil T. Market evaluation of off-balance sheet financing: You can run but you can’t hide (December 1, 2003). EFMA 2004 Basel Meetings Paper.
Lubove, Seth & MacDonald, Elizabeth. (2002, February). Debt? Who, me? Forbes, 169(4), 56-57. Retrieved February 3, 2011, from Accounting Tax & Periodicals.
Spiceland, D., Sepe, J., Nelson, M., & Tomassini, L. (2009). Intermediate accounting (5th ed.). New York, NY: McGraw-Hill Companies, Inc.