Lease Accounting

Lease Accounting

Lease Accounting

Introduction

The Financial Accounting Standards Board has released a proposed change to lease accounting that would have an immediate and substantial impact on businesses and nonprofit organizations of all sizes that are either lessees or lessors of real property and/or equipment. This article will focus on the impact on lessees. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued a discussion paper proposing changes to the existing lease accounting rules that would eliminate the current off-balance sheet treatment of operating leases (FASB, 2009). The proposed rules will eliminate the current classification of leases as either finance or operating leases and instead require a single model in which lessees will capitalize all leases as assets and liabilities on the balance sheet at the discounted present value (PV) of the expected lease payments. The leased asset will be depreciated over the shorter term of the lease or the economic life of the asset, whereas the lease payment would be allocated between a reduction in the outstanding principal lease liability and interest expense instead of expensing the entire lease payment (FASB, 2009). In nutshell, from the point of view of the lessee, a lease transaction represents an off-the balance-sheet transaction and this appears to be an important advantage associated with leasing (Bennett, Bradbury, 2003, 101-114). It may be noted that in countries like the United States and the United Kingdom, where leasing is very popular, leases which meet certain criteria are capitalised in the books of the lessee.

This essentially implies that:

The leased asset and the corresponding liability (reckoned at the present value of the stream of rental payments) are shown on the balance sheet of the lessee.

Depreciation charges are claimed by the lessee, and

The lease rental is split into two parts, the interest component (which is charged to the profit and loss statement) and the principal repayment component.

Discussion

This article is motivated by the impending changes in lease accounting that will require the capitalization of all operating leases. An exposure draft of the new rules is expected to be issued in 2010 with final implementation in 2012 (Ringer, 2000, 104-105). The proposed changes have raised concerns among companies worried about the potential negative impact on financial statement presentation and certain financial ratios that are widely used in debt agreements and executive compensation plans. Companies are concerned that the proposed changes will dramatically change the amount of debt and assets that is capitalized on the balance sheet and the location and amount of expenses recognized on the income statement (Fülbier, Silva, Pferdehirt, 2006, 56-101). Moreover, the capitalization of operating leases is expected to significantly affect various debt-related ratios such as leverage, times interest earned, and debt-to-equity ratios, among other ratios, that are widely used to evaluate a company's financial performance and compliance with debt covenants.

The study will contribute to the existing literature on leasing in the following ways (Imhoff, Wright, 2004, 51-63). First, this study will show how the presentation of financial statements will change dramatically ...