Analysis Current And Proposed Lease Accounting Standards Finance Essay
Currently, the companies has the right to use assets which including land and buildings acquired under operating lease contracts is not currently recognized on the balance sheet which is under the International Accounting Standard (IAS) 17. (Goodcare, 2003). In this case, in recent years, firms have been gives more latitude in recording leases as operating lease to make sure them to keep billions of lease liabilities off of their balance sheet (Duke & Hsieh, 2006). Therefore, those activities will course the firm’s leasing arrangements usually cannot reflected accurately and completely in the company’s financial statements. Obviously, the current situation arises directly from recognized advantages of existing lease accounting standards, which is under the IAS 17(Pounder, 2009). Since that, the IASB and the FASB have published a joint discussion paper in 1996 and 2000 respectively about lease accounting standard in which they propose that operating leases are capitalized on the balance sheets as well as finance lease. And also, many researches have focused on the potential impact of the proposed changes in accounting for leases. The aim of this paper is to analysis the current and proposed lease accounting standards which link to the ISAB’s conceptual framework.
Current lease standards
According to the IAS 17(1982), a lease “is an agreement whereby the lessor conveys to the lessee in return for rent the right to use an asset for an agreed period of time.” The IAS 17 has identified two types of lease which are finance lease and operating lease and requires a totally different accounting treatment for each. A lease that “transfers substantially all the risks and rewards incident to ownership of an asset” is a finance lease. Therefore, under the finance lease contracts, asset should show on the lease’s balance sheet at the present value of the minimum lease payments and a corresponding liability is recognized. On the other hand, a lease which does not transfer substantially all the risks and rewards of ownership to the lessee is treated to be an operating lease. Under an operating lease the full value of the leased item is treated as an asset of the lessor and the lessee simply recognizes the rental payment as an expense, with limited additional footnote disclosure of future lease rental commitments.
The existing lease accounting standards have been widely discussed and many researchers think that it could be have more development. The preparers of financial statements are required to recognize whether are finance or operating lease. Making this distinction as required by existing lease standards is very cumbersome to prepares and is of limited usefulness to the users of financial statement such as investors, creditors, securities analysts. Furthermore, it let the company have the opportunity to misclassify leases as operating lease to avoid recognizing legitimate assets and liabilities on their balance sheet (Pounder, 2009).
Proposed standard for leases
Since many problems have risen from the current standards, in 1996, the G4+1 published a special report entitled Accounting for leases: A new approach (McGregor, 1996). According to McGregor (1996), currents lease standards fail to record the assets and liberalities on most operating lease contracts. And in the report, he developed a new approach which is requiring lessees to recognize a liability associated with the present value of their unavoidable rent obligations for all leases having initial noncancelable terms greater than one year. And in 2000, the FASB and G4+1 jointly published a second special report entitled Leases: Implementation of a New Approach (Nailor & Lennard, 2000). This report discussed McGregor’s new approach in detail and incorporated into a comprehensive new lease accounting standard (Monson, 2001).More recently, in 2009, the FASB and IASB have proposed their preliminary views on several important elements of a proposed model for future lease accounting. The key elements of the Boards’ proposal are 1) expurgating the finance and operating leases distinction and 2) a requirement to capitalize all leases on the lessee’s balance sheet (Pounder, 2009).
Since IASB have adopted their conceptual framework, all the researchers have focused their standard setting activities on the balance sheet, which guided by their respective framework’s definitions of assets and liabilities. In the IASB’s framework (1989): No.6 The Elements of Financial Statements defines assets as “a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity, and it defines liabilities as “a present obligation of the entity arising from past events, the settlements of which is expected to result in an outflow from the entity of resources embodying economic benefits.” And in their discussion paper on lease accounting, they proposed all leases are similar in economic substance. More importantly, they have concluded that the lessees have a right to use leased property quality the definition of an asset. At the same time they have concluded to make rental payments to the lessor qualify the definition of a liability (Pounder, 2009).
The IASB’s conceptual Framework
-A conceptual model for choosing
Whether or not to promote the new leasing standards, the standard setters should consider the current and proposed lease accounting by using the IASB’s own conceptual framework. In IASB’s framework, the objective of the financial statements is to “provide information about financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions”. And also, in the framework, the qualitative characteristics of financial statements are the characteristics that make the information provided in financial statements meaningful and useful to users. The major four principle qualitative characteristics are understandability, relevance, reliability and comparability (IASB, 1989). These characteristics can be viewed as the cornerstone to determine whether the decision is usefulness (Monson, 2001).Generally summarized, it is to provide the useful financial statements which satisfy those four qualitative characteristics to different users.
For the current lease accounting standards, operating lease have been widely used because the company can effectively keep both the leased assets and the liabilities off the balance sheet and only disclose the future lease payments (Duke &Hsieh, 2006). Those activities will obviously cause the financial statement unreliable, and easily misunderstand the users. Enron’s collapse showed how easily a company could hide debt. Due tocurrent rule-based accounting standards for leases, companies can and have continued to rely on operating leases to hide significant amounts of liabilities even in the post-Enron era (Weil, 2004).
Furthermore, Weil (2004) also explained the major shortcoming of operating lease. If the present value of a company’s minimum lease payments equals 90% or more of a property’s value, the transaction must be treated as a finance lease, with accounting treatment akin to that of debt. If the figure is slightly less, like 89.9%, the lease is treated as operating lease. Then the lease commitment appears not in the main body of the financial statements but in footnotes, and leaving the users of financial statement to do the math themselves, often obscurely written and of limited usefulness (Weil, 2004). For example, he identified six firms as significant users of operating lease to keep lease liabilities off balance sheet. In his research, he found that these off balance obligations can be huge. For example, for the company’s in the Standard & Poor’s 500 stock index, off balance sheet operating lease commitments, as revealed in the footnotes to their financial statements, total $482 billion in 2004.
And even although a finance lease is at a disadvantage compared with an operating lease in reporting more liabilities, it does have a tax savings advantages over operating lease. This is because in the early life of lease term, a finance lease reports a larger expense. However, many retailers still favor operating lease over finance lease because it will show the healthy ratio of the company according to the financial statements.
It seemed like the current lease accounting has many disadvantages. On the other hand, if the operating leases are being capitalized, it will change the behavior of any of the interested parties (Goodcare, 2003).
For external users of financial statements, some users think that capitalize the operating lease is useful, some are not. As mentioned buy the framework, if the standard setters want to propose the new lease accounting, the information that provides to the users must be new, valuable and useful. However, the research in recent years is very conflicting.
For example, Abdel-khalik (1981) has a research on whether to capitalize the operating lease or put them in the footnote by using a range of interested participants. He found that external users such as the investors, analysts and lenders have a preference for a company that reported the leases in a footnote over an identical company that capitalized leases on-balance sheet. Wilkins and Zimmer (1983a) and Wilkins (1984) also found that the external users’ decisions were affected by levels of leverage but not by the method of accounting. And in Gopalakrishnan and Parkash’s research (1996), they found that different users have different preference. Lenders are more likely than managers or the preparers to regard disclosed obligations as debt. Breton and Taffler (1995) conducted a laboratory experiment using UK investment analysts to investigate their response to nine forms of creative accounting, one of which was non-capitalized leases.
On the other hand, some researchers also show the evidence that users are not misled by such presentational issues. Especially, Beattie et al (2000) and Imhoff et al (1993) have shown the evidence for both the UK and the US that the users in market already incorporates footnote operating lease disclosures in its assessment of equity risk. Further, Dresdner Kleinwort Benson (1998) have identified that some investors and analysts have already reviewed financial statements by calculating the assets and liabilities implicit in off-balance sheet operating leases. It seems that any changes in reported performance resulting from the accounting changes are probably already impounded in stock market prices.
What is the right approach?
IASB want to create the desired transparency of companies by changing the lease accounting and expand disclosure requirements. McGregor (1996) originally suggested not capitalizing leases with initial noncancelable terms less than one year. Nailor and Lennard (2000) suggest only recording assets and liabilities for those rights and obligations that are material. Heffes (2006) also mentioned that there are certain lease should not be capitalized. For example, Immaterial could be defined as the lease of an asset of less than $50,000 in cost where the original lease term is 48months or less. This approach would eliminate the burden of having to capitalize immaterial items and account for deferred taxes, and it more truly portrays the commercial intent that these transactions are an operating lease. Additionally, this materiality cutoff cause less than 15 percent off the current volume of reported minimum lease payments under operating leases to avoid capitalization.
The IASB should properly develop the lease accounting standards and it must decide how its definitions of assets and liabilities should be applied to the rights and obligations arising out of lease contracts according to the conceptual framework.
Overall, even after the IASB decides whether or not to propose the new approach, it seems that it is impossible to adopt a lease standard which requiring to record assets and liabilities for every lease. The IASB should reconsider and promote the new lease accounting carefully, because any changes to the accounting standards will cause the lots of the reaction not only for the company itself but also the market.
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