Accounting for Leases 4

Introduction Accounting for leases is regulated by the Financial Accounting Standards Board (FASB) in United States . Standards for accounting leases have been effective since 1977 (Accounting Standard Board, 2004).

The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13). According to FASB (1976), a lease is an agreement conveying the right to use property, plant, and equipment (PPE) usually for a stated period of time. Examples of assets that can be leased include land, buildings, and plant & equipment.FASB classified lease as an operating lease or a capital lease (finance lease).

An operating lease is regularly for a shorter period of time and is a rental of the asset. Under an operating lease, the lessee does not identify the asset or liability related with the leased asset, it recognizes lease payments as an expense (Elena, Catalina, Stefana & Niculina, 2009). As for lessors, current accounting guidance requires that lessors recognize a lease as one of the following: sales type lease, direct financing lease, leveraged lease or operating lease.Capital leases are those leases that transfer to the lessee substantively all the risks and rewards to ownership of the leased asset (Beattie, Goodacre & Thomson, 2009).

Under a capital lease, the lessee identifies in its balance sheet the leased asset and is responsible in paying rentals. The lessee depreciates the leased asset and distributes lease payments between a finance charge and a decrease of the remaining liability (KPMG, 2010). BodyThe standard setters realized that the primary standards set previously were inappropriate and need to be change. One of the main reasons is the current lease accounting model has raised several of criticism for many years.

Financial statement users have argued that some operating leases give rise to assets (the right to use the leased asset) and liabilities (the obligation to pay rentals) (Beattie et. al, 2009). Thus, users have struggled to capitalize the asset when evaluating a company's financial statements and projecting predictions.Moreover, criticism has been made that the existing lease rules are complicated and that the bright line tests are very challenging to apply (Nobes, 2004). As such, similar transactions can be accounted in a different ways, resulting in reducing comparability for users. Additionally, arguments have been made that the current standards give opportunities for companies to structure leases and to obtain a specific lease classification (Ernest ; Young, 2010).

The US Securities and Exchange Commission (SEC) realised that the current lease accounting model is conceptually faulty in June 2005 Report and has been recommended that the FASB commence a project to re-evaluate the leasing standards, if possible as a joint project with the International Accounting Standards Board (IASB) (Kohlbecks and Warfield, 2005). As a result, In July 2006, there are several changes being discussed by FASB and the accountant community over lease accounting in the United States.FASB and IASB announced the commencement of a joint project to carefully re-examine lease accounting. In March 19, 2009, FASB and IASB issued a joint discussion paper on March 19, 2009 titled Leases: Preliminary Views. On 17 August 2010, IASB and FASB published a joint exposure draft ED 2010/9 Leases (Elena, Catalina, Stefana and Niculina (2009). FASB has proposed changes to the accounting for lease arrangements that might have a significant influence on the public and private firms.

The boards' stated intention is to recognize an asset and obligation for all leases, basically making all leases capital leases (Nobes, 2004). Changes also occurs because current lease accounting standards does not meet the needs of users of financial statements, where liabilities relating to operating leases are underreported, and the categorization of operating and finance leases is inconsistent and highly susceptible to structuring a transaction to achieve a desired accounting treatment (KPMG, 2010).Furthermore, FASB wish to produce a common standard on lease accounting to have higher level of transparency and comparability to financial statements and to improve on the understanding of financial reporting (Altamuro, 2005). The proposed new accounting standards treat all leases as capital leases. This will get rid of the difference between capital leases and operating leases (Nobes, 2004).

FASB and IASB consider that when issuing a lease contract, a lessee has attained an asset through its right to use the asset and recognized a liability through its duty to pay rentals.Using the new standard, a lessee is required to record an asset on behalf of its right to use the leased item on an agreed term and a liability for its obligation to make pay rental fees. As for primary measurement, it was cautiously decided that the lessee would record the asset at cost, which would equal the present value of the lease payments discounted at the lessee's incremental borrowing rate. The obligation to make rent payments would be recorded at the present value of the lease payments, discounted at the lessee's incremental borrowing rate (Ochoa, 2011).After several meetings, the Boards decided to implement the performance obligation approach to lessor accounting where a lessor would identify an asset representing its right to receive rental payments and distinguish a liability representing its performance obligation under the lease (Elena et. al.

, 2009). Revenue will not be recognized at beginning of the lease but will be recognized over the lease period. Another proposed change is the treatment of options to renew a lease. Current standards only allow consideration of renewal options where renewal is rationally certain.

The new standards would require the lessee and lessor to assume that the lease term contains all renewal options that are more likely than not to be exercised. As a result, there will be an increase in the use of renewal options in calculating leasing assets and liabilities as well as increasing the amount of subjective judgment in deciding what renewal options (Fletcher, Freeman, Sultanav, Umarav, 2005). The proposed changes will affect almost all companies. Leasing companies that base their business on the leasing of assets to other companies will mainly be affected by the changes.Companies that lease assets will have to capitalize those assets. Their balance sheets will be significantly overstated and companies will appear to be more highly leveraged (Elena et.

al. , 2009). Besides, lease expense will not be constant over the period of the lease since they were under operating leases. Lease costs will be higher in the lease’s earlier years and lower in the later years because the lease liability will be amortized using the effective interest way (IFRS Global Office, 2010).As a result, several key leverage and capital ratios may be affected. Furthermore, interest coverage ratios would suffer, but measures such as EBIT and EBITDA would improve because lease expense would be reclassified as interest expense, including the amortization charge.

The lease accounting changes will eventually raise the issue from the regulators about tis creditability which might be important in creating public confidence in the practice of accounting.Hence, conceptual framework is to assist standard setters to harmonize accounting practices, standards and procedures, and to ensure that accounting standards published by accounting bodies are inherently consistent, as they will then theoretically all adapt to the framework (Vorster, 2007). Conceptual framework is important since other concepts flow from it and repeated references to it. It is essential in establishing, interpreting and applying accounting and reporting standard.

Conceptual framework is proposed to act as a structure for the standards-setting process or provide a basis for the creation of accounting standards (Zeff, 1999). It acts as guidance in determining accounting thoughts that arise during the standard-setting process by reducing the question to whether or not specific standards obey to the conceptual framework. Godfrey (2000) states that accounting practice is very permissive because accounting standards allow some alternatives accounting practices to be applied to similar circumstances.Thus, there is a need for somebody to make a judgment about the type of accounting standard, which is necessary and applicable. Conceptual framework should not be more than just providing broad and general objectives for financial reporting to avoid any objections and provide a basis for reducing the number of alternative accounting treatments (Peasnell, 1982).

Conclusion While the lease accounting changes are not expected to be effective until 2013 at the earliest, entities entering into new leases today must be alert on the likely future impact of the proposal on their financial statements.Changes to the financial statements may have major effects on business evaluation methodologies, measurement of employee performance and so on. The diagnostics valuations, system requirements, and implementations will require significant time and effort. Properties may become constrained as the effective date is closer. Hence, companies should focus on how to deal with the impact of the proposed changes on both the accounting and reporting and its operations.It is important to prepare for the essential lease management and changes in financial reporting process and systems.

Besides, analyzing current lease terms and restructuring leases, companies should opportunistically exercise purchase options if applicable before proposed rules are effective. Companies that start to prepare for the change now will have a much smoother change and will be in a better situation to capitalize the leased asset and also upon the rule changes to make the most financially advantageous transactions. (1496 words)