Examining the capitalisation of operating leases - Free Essay Example

The International Accounting Standards Board is currently proposing that operating leases as well as finance leases are capitalized on the Statements of Financial Position (Balance Sheets) of lessees. This has caused a widespread debate between academics, regulators, the profession and users. Many of the arguments in favour of this treatment are based on the fact that it can be justified in terms of the Framework for the Preparation and Presentation of Financial Statements, but there is no universal agreement with this view. 1.0 Introduction The IAS (International Accounting Standard) 17 prescribes for lessees are lessors the appropriate accounting policies and disclosures to apply in relation to finance and operating leases. The separate treatment of finance and operating leases since 1982 has triggered recent large debate and prompted the initiation of change and improvement. It is beneficial to use the International Accounting Standards Board (IASB) Financial Framework to highlight all crucial points of view in terms of users and highlight that there is no perfect, universal approach. 1.1 Current Accounting Treatment of Leases The International Financial Reporting Standards (IFRS) establish that a finance lease occurs when all of the risks and benefits of ownership are substantially transferred to the lessee (Delaney Whittington, 2010) from the lessor, as well as considering four important conditions; please see Appendix I for details and characteristics. Since the introduction of SSAP 21 the accounting treatment for a finance lease for the lessee is to recognise it as both an asset and liability on the Statements of Financial Position (balance sheet), these are, respectively, representing the lease and the lessor as a creditor to which payments are obliged to be paid. The difference between the minimum lease payments and the present value of the minimum payments is charged to the Statements of Comprehensive Income (income statement) as finance (interest) charges. This mirrors the treatment for the lessor; the lessee is shown as a debtor and the payments of the lease as income. All leases which do not satisfy the finance lease criteria are operating leases. For the lessee, the lease is reported on the income statement as rental income and the future liability of payments are fully disclosed in the footnotes of the financial statements. In contrast, the lessor shows the payments received as rental income in the income statement. Operating leases do not affect the balance sheet for the lessor or lessee. 1.2 The IASB Proposed Change In August 2010 the IASB published a proposal to change the future of leases through the capitalisation of operating leases. It has been estimated by Sir David Tweedie that $640 billion of lease obligations are annually excluded from the balance sheet by being classified as operating leases; this fails to provide users with a true impression of an entitys liabilities and gearing. This is a fundamental change in the transfer of risks and rewards approach by replacing it with the right of use model; the lessee will recognise the asset for their right of use from the lease and the liability for the commitment to maintain payments. (Durocher Fortin, 2010). The Financial Framework The IASB Financial Framework can be utilised to analyse both the accounting standards in place and the proposed changes for both theoretical and practical purposes. It applies essential concepts that underlie both the preparation and presentation of financial statements for external users (Belverd Powers, 2009; IAS, 2010) which evaluates accounting standards as a guide to ensure standards are relevant and reliable. 2.1 The Objectives of Financial Reporting The users of financial accounts are the investors, creditors and other groups and individuals outside and inside the company who must make economic decisions based on these statements (Porter Norton, 2009). The underlying objective of the reports is to provide the users with a true and fair view of the financial position, performance and changes in financial position that is informative in decision making (Benny, 2005). Through capitalising operating leases onto the balance sheet more information will be readily available to lenders; they will be able to evaluate the long-term financial commitments and make superior estimations on the level of risk involved. Lenders will not be able to form reliable, accurate decisions if material the measurement and admission of all information accessible on the financial statements (Schroeder et al, 2010) operating leases are kept off of the balance sheet. Lessees often choose to disclose the operating lease on the income statement to avoid a decrease on their accounting ratios, particularly the gearing ratio which is most vital to investors to show a companys ability to repay their debt. However, this is not recognising all financial assets and liabilities. 2.2. Qualitative Characteristics The IASB have four key characteristics which ascertain the value and use of the financial information for the users, these are; reliability, relevance, comparability and understandability (Elliot Elliot, 2008). 2.2.1 Relevance of Financial Statements The relevance of financial accounts is how competent an entity is at presenting their financial information to aid users form predictions upon the outcome of future events (Clyde et al, 2009). The information is required to be relevant to something depending on the users need or decision; this can include lenders for investment decisions. If operating leases are not capitalised, assets and liabilities may be overstated as well as investor decisions based on the companys liquidity, ability to pay and financial performance will be formed upon limited information. A study carried out by Williams, Chen Tearney (1991) found private business bankers prefer leases to be capitalised onto the balance sheet as they were extensively more relevant and significantly more cost-effective (Durocher Fortin, 2010). 2.2.2 Reliability of Financial Statements Financial statements are deemed to be reliable if they are free from material error, give a true and fair view which is free from bias, is capable of verification and can be depended upon (Cairns, 2002). The IAS 17 states the classification of a lease depends on the substance of the transaction rather than the form, this should be the focal consideration which affects the accounting treatment of leases. The Framework adopts the prudence concept to ensure assets are not overstated and liabilities are not understated, this is a neutral approach under uncertain conditions. Operating leases which are disclosed within the lessees income statement will not be dependable for users of the accounts as it ignores the future liability, forward-looking accounting and the heuristic method (rule of thumb) which exceedingly overstates impending lease liabilities (Imhoff, 1993; Kilpatrick Wilburn, 2006). The capitalisation of all leases will improve the reliability and accuracy of financial ac counts and evaluations made upon these including more realistic ratios. Duke Hsieh (2006) state that operating leases can be used to hide billions of liabilities from investors, report favourable net income and retained earnings, and present a significantly improved debt/equity ratio and a rosier return on assets ratio, this may be due to the bias of the creator or manager of the financial accounts to make them more attractive. This greatly supports the proposed recognition of operating leases with the same treatment as finance leases so all leases, regardless of monetary value, are on the balance sheet to avoid under- or overstating assets and liabilities for the purpose of users decisions. 2.2.3 Comparability of Financial Statements It is valuable for the users of financial statements to be able to compare a companys financial performance and position trends over time and against other entities (Rolfe, 2008). The IASB proposal to capitalise all leases will provide companies with strict rule-based procedures to follow in order to adhere with the standards; this uniformity and consistency across all companies will allow users, such as investors, to compare crucial figures including the gearing ratio and their long term financial commitments to make superior informed decisions. It will also allow managers to compare their financial information with competitors to improve internally. If operating leases continue to be disclosed on the income statement the users are unable to view the material value of individual leases. Supporting this, Berry Robertson (2006) found that bankers feel that incorporating off-balance sheet information into the balance sheet will improve investment evaluations for users and thus, t his will progress the accounting stability across all industries. 2.2.4 Understandability of Financial Statements The business entities are responsible to provide financial statements that are readily available for users who are believed to have sufficient knowledge of business and economic activities and accounting, as well as a willingness and responsibility to study the provided information with a reasonable diligence (Booysen et al, 2008; McCrary, 2009). Financial statements are not prepared for lay users and the business must be aware of their users to make their information valuable and useful. Investors are less likely to pay more attention to operating leases which only feature on the income statement when making investment decisions as they are not fully aware of the lease as a whole. Lessees may not wish to recognise all of their leases onto the balance sheet as it reveals further information which they may not want their competition to be aware of as it increases the risk of their business and it may deter those who are able to critically comprehend the financial information. 2.3 The Elements of Financial Statements The fundamental elements of financial statements are those of asset and liability since each of the other elements are defined in terms of its relationship to an entitys assets or liabilities (Melville, 2008). An asset can be defined as one which provides future economic benefit to the business as well as gaining absolute control over the asset (Epstein Jermakowicz, 2010; Mard et al, 2010); an operating lease satisfies this criterion and therefore should be recognised onto the balance sheet to provide users with a true and fair view of the financial position of an entity. Although this will disrupt the lessees profitability and it is argued by Goodacre (2003) that off-balance sheet operating lease are shown to be a major source of finance and are more important than on-balance sheet long-term debt. Yet, in opposition to Goodacre, an operating lease should be capitalised as it also fulfils the definition of a liability; a present obligation resulting from a past event (IAS 37). Disclosing an operating lease ignores the accrual concept of looking at future financial commitments to maintain the lessees ownership on the lease over a specific period of time. 2.4 Recognition of the Financial Elements A financial element should be recognised onto the balance sheet as soon as the entity has engaged in the contractual provisions of the instrument (Gowthorpe, 2007). An asset must feature on the balance sheet if it complies with three conditions; a past event to acquire the asset, future economic benefits and the entity must have ownership and control. A finance lease certainly fulfils these measures and an operating lease also; the lessee entered into a contract with the lessor to benefit from the use of an asset whilst retaining the control and responsibility for the agreed period. By recognising the lease onto the balance sheet users are able to have an enhanced reflection over the economic benefits of ownership and it allows the entity to manage their balance of assets and liabilities. 2.5 Measurement of Financial Elements The IAS 39 (to be replaced in 2013 with the IFRS 9) details that financial elements should be measured at fair value; the IFRS 7 supplements this rule as entities are to disclose their financial instruments. This enables users to evaluate the impact upon the financial performance and position of the entity; it measures the possible risk exposure, improves transparency and the overall quality of information (Everyingham et al, 2008; Zyla, 2009). The fair value of the leases at the time of commencement is capitalised onto the balance sheet in accordance with the substance over form principle, at present, operating leases do not conform to this (Booysen, 2008). If operating leases are capitalised onto the balance sheet it will adversely affect up to nine major financial ratios, particularly the gearing ratio, which are mainly used by bankers for investment decisions (Beattie et al, 1998). For this reason it is beneficial for entities to disclose these within their income to avoid t horough assessment of risk by users of the financial statements. Oswald (2000) discussed that the introduction of the capitalisation of leases must consider the exchange of cost-benefit between the disclosure and recognition of leases, therefore the increased transparency may initially have detrimental effect on the lessees, yet for long-term finance it will improve consistency and reliability of the financial statements. 3.0 Conclusion It has been confirmed that the current, almost arbitrary, treatment of leases has never been adequate to satisfy both regulators and users of financial statements (Durocher Fortin, 2010; Lyon, 2010). The majority of research has agreed with the IASB proposal to capitalise operating leases to be consistent with finance leases; this will simplify the accounting concept whilst being in accordance with the treatment of financial instruments, and prevent possible accounting schemes to disclose material leases on the income statement. Although, it may significantly affect the financial ratios of specialised industries such as the airline industry that rely on short-term operating leases to rapidly adjust their capacity in relation to demand (Sutton, 2004), the long term benefits will outweigh this. The improved, accurate balance sheet will provide users with greater transparency and further information to aid decision making so it is more reliable and less risky. The IASB is encouraged to adopt the suitable right-of-use model to account for an operating lease on the balance sheet; the marginal administration burden on companies does not overshadow the benefits of comparability and consistency with accounting standards and treatment.