Accounting for Leases - Historical Development of Lease Accounting - Case Study Example

Accounting for Leases

Historical Development of Lease Accounting.

Leasing is a critical practice for both public and private organizations. According to Eisfeldt & Rampini, (2009), leasing allow firms to access assets, gain financing, and minimize their risk exposure of property ownership. Businesses organizations mostly lease real estates, trucks, ships, and manufacturing equipment among others. The need for risk minimization when acquiring capital assets increases the popularity of leasing. Therefore, it is prudent that consumers of financial statements information understand the depth of an organization leasing activities. Ideally, the historical development of lease accounting models and frameworks for calculation fall in three parts. The parts are the standards that existed before statement 13 and IAS 17, during the issuance of Statement 13 and IAS 17, and G4 +1 after the establishment of statement 13 and IAS 17.

One of the initial guidelines concerning lease accounting was ARB No. 38, which was issued in 1949 by the Committee on Accounting Procedure of the American Institute of Accountants (Boyle, Carpenter, & Mahoney, 2014). At the time of issuing ARB 38, accounting professionals worried that companies were not reporting leases as liabilities, which gave misleading information. The Committee provided that business should disclose long-term material losses in their financial statements or notes. Additionally, the agreement was that the disclosure should include the annual amounts repayable, the period of repayment, and any obligation related to the lease agreement. However, ARB 38 is not applicable to short-term leases because lessees rarely assume costs and responsibilities of ownership in short-term leases. Importantly, the Committee rejected the leases be considered as assets because the lessee holds no legal title to the property; hence, making them recognized as liabilities.

Since ARB 38 did not indicate any accepted definition of liabilities or assets in its conclusions, it left room for much further interpretation about the definition of property or liabilities about leases. In 1962, the AICPA issued a research study, ARS No. 4, in which John Myers recommended that lessors recognize transfer of property rights by shifting an asset out of the fixed assets section to the accounts receivable section of the balance sheet. Considering the double entry perspective, it is evident that lessee would record such a transaction as property, which is an asset. Myers model for lease transactions was adopted in ARB 43. In 1964, Opinion No. 5 came in place as an issuance of the Accounting Principles Board (APB) to replace ARB43, Chapter 14. Lack of consistent trends concerning lease disclosure and capitalization of lease property or related obligations prompted APB to issue Opinion 5 (Anderson, 2014). Therefore, APB concluded that nonequity-creating lease contracts did result in asset or liabilities recognition. Instead, such leases are included in the footnotes in financial statements.

Progressively, new developments came up as APB issued Opinion No. 7 in 1966, which was the first standard to explain lessor accounting explicitly. At that time, the primary concern for lessors was revenue and expenses allocation mechanism in different periods covered by the lease. Opinion 7 posited that business should report leased assets separately from other assets because the investments from lease activities are neither receivable nor facilities in typical commercial operations. However, Opinion 7 did not clarify when a manufacturer or lessor should account lease transactions with an independent lessee just as a regular sale. Resultantly, APB issued Opinion No. 27 that specified a mechanism reflecting a transfer of ownership risks or rewards. According to Opinion 7, a lessor could consider a lease as a sale on conditions that assurance for payment collection exists and no critical risks concerning future costs existed. As usual, Opinion 7 did nit clarify any definition of assets or liabilities the same way earlier views never explained.

In 1972, the Securities Exchange Commission (SEC) issued ASR No. 132. ASR 132 evaluated how a lessee should recognize a lease in which a lessor with no actual economic substance apart from the being means of financing a debt by the lessee. In short, SEC concluded that the lessee should consider such contracts as purchase agreements and capitalize the lease. Again, APB issued Opinion No. 31 in 1973 that advocated for more elaborate and uniform disclosure if rental obligations for non-capitalized lease. The opinion required firms to disclose minimum rental obligations for five years succeeding financial years. Moreover, opinion 31 required disclosure of framework for calculating rental payments, terms of renewal, guarantees if available, and other auxiliary information. However, SEC issued ASR No. 147 to contrast Opinion 31. SEC argued that APB required substantially less disclosure in Opinion 31 that originally stipulated by SEC. As a solution, SEC provides the most elaborate disclosure that required firms to present value of financial leases and influence on the net profit of lease capitalization (Meyer, 2013). In 1974, a discussion memorandum (DM) was issued by the Financial Accounting Standards Board (FASB). In the DM, FASB discussed lease models such as purchase, legal debt, property rights (asset), liability, and executory contract. FASB proposed a list of models applicable to lease transactions. In 1975 and 1976, FASB issued Exposure Drafts (ED) to harmonize earlier deliberations of lease accounting.

In 1976, FASB issued Statement 13, which as summary of ED 1976 and 1975. Statement 13 established standards of financial accounting and reporting for leases, lessees, and lessors. For lessees, an item is a lease financing transaction if it is operating lease. Lessee considers capital leases as assets upon which lessee incur obligations. Operating leases are more of current operating expenses for the lessee. However, lessors consider financial transaction lease as a sale-type, direct financing or leveraged lease (FASB, 2016). Importantly, Statement 13 outlines criteria that a lease should satisfy for consideration as either operating, financial, or sale-type. IAS 17 came in 1980. Under IAS 17, classification of leases is either finance or operating. Finance leases involve a substantial transfer of all risks as well as rewards of ownership. Lessee recognizes financing leases as assets and liabilities while lessors recognize them as receivable. In operating leases, lessee recognizes them as expenses while lessor recognizes remainder as assets. Revision of IAS 17 occurred in 1996, 1997, and 2003 to align with new developments in lease accounting.

As a progressive towards ensuring regular updates on lease accounting, a group called G4+1 undertakes a study on leasing. The group consists of the United Kingdom, the US, Canada, New Zealand, Australia, and the International Accounting Standards Committee (IASC). Initial special reports of the G4+1 group came in 1996 and 1999. The 1999 report G4+1 special report concluded that the difference between finance and operating leases required by the then accounting standard was arbitrary and not satisfying. The main reason was that lessees’ balance sheet leaves out significant assets and liabilities resulting from operating leases. Such material omission influenced reported values of debt-to-equity ratio, return on capital employed, indebtedness, and interest coverage. In summary, the 1996 special reported suggested for the development of an approach that applied the same to all lease requirements as a way of enhancing comparability and usefulness of financial statements. The 1999 special report evaluated the current concept of operating leases but asserted that such treatment would results into liabilities and assets only to the fair values, obligations, and rights related to the lease.

Current Generally Accepted Accounting Principles (GAAP).

Lease transactions become more familiar with time as firms seek alternative mechanisms for financing long-term assets. Under the current GAAP, lease accounting falls in Accounting Standards Codification (ASC) 840. The code has four subtopics including overall, operating leases, sale-leaseback transactions, and capital leases (Flood, 2014). ASC 840-10 defines the classification of leases and offer accounting as well as financial reporting guidelines that apply. ASC 840-20 evaluates accounting involving lessee and lessors for leases classified as operating leases in ASC 840-10. ASC 840-30 explains accounting involving leases classified as capital under ASC 840-10. ASC 840-40 addresses accounting pertaining sale-leaseback transaction leases. Ideally, sale-leaseback transitions occur when the property owner leases back the property initially leased out by him or her.

Comparing and Contrast GAAP and IFRS on Lease Accounting

IFRs and GAAP show some differences concerning lease accounting. Regarding scope, GAAP defines, in ASC 840, a lease as a covenant containing the right to use land or depreciable assets for a particular period. IFRS' IAS 17 describe leases as the transfer of rights to use assets, but substantial lessor services may be called for such as operations and maintenance of the property specified in the agreement. In short, IAS 17 includes rights to use additional assets. Intangible assets fall within the scope of IAS 17 provided they rights define the exclusive use of such assets.

Lease classification under GAAP depends on whether the lease fits the outlined criteria in ASC 840-10-25-1. A financial lease is classified as so if they meet additional criteria in AC840-10-25-42, which are collectability of payments from lease agreement is reasonably predictable and no critical uncertainties threaten payment collection. However, IFRs classification of leases does not depend on meeting specified criteria. Rather, lease classification under IFRs depends on the nature of the lease, that is, finance or operating. In as much as paragraph 10 and 11 of IAS 17 provide some criteria for classifying lease as finance, they are not always determinants of a lease’s categorization; paragraph 12 asserts the point.

Still, GAAP distinguishes sales-type lease from direct financing and leveraging lease based on their ability to give profits to manufacturers or the lessor. With an exception of lease related to real estate, GAAP provides that the lease must satisfy one or more criteria in ASC 840-1—25-1 as well as the conditions in ASC 840-10-25-42. For real estate related lease, sales-type lease only occurs if the lessor shifts the ownership upon the end of lease period. On the contrary, IFRs do not differentiate sales-type leases from other forms of finance leases though paragraphs 42–46 of IAS 17 explains accounting treatment that results in profits or loss of manufacturers or dealer lessors.

GAAP, ASC 840-10-25-38, provides that land and building elements are recognized as a single unit unless lease transfers ownership at the end of lease term, the lease has a purchase option, and fair value of land is 25% or more of a total fair value of leased property. IFRs IAS 17 paragraph 15A states that a lease involving both land and buildings elements is classified as either finance or an operating lease on paragraphs 7-13. Land indefinite economic value is an important consideration when determining whether an item is operating or a finance lease. IAS Paragraph 17 further states that lease payments allocation between the land and buildings aspects in based on the fair values of interest they attract.

Another point of difference between IFRs and GAAP is the present values of minimum lease repayments. Under GAAP, ASC 840-10-25-31, lessee applies incremental borrowing rate to determine the minimum lease payments unless the actual rate is known or lower. Under IFRs, lessees always use the rate clear in the lease to discount minimum lease payments in accordance with IAS 17 paragraph 20.

Additionally, IFRs and GAAP differ on their explanations for leveraged leases. GAAP, ASC 840, provides conditions to meet before recording leveraged lease as well as the accounting for transactions resulting from leveraged lease transactions. ASC 840-10-25-43 states outlines the criteria in detail. Distinctively, paragraph 840-30-25-8 explains that the lessor’s net investment declines when the repayment is not yet complete and rise upon repayment is over. However, IFRs does not provide any special accounting treatment for leveraged leases because all leases are recognized as either finance or operating lease.

One similarity between GAAP and IFRs concerning leases is their recognition of loss or gain on sale-leaseback transactions, which differs based on the leaseback classification. GAAP provides different conditions for sale-leaseback truncations related to real estate. ASC 840-40 outlines the specific criteria for recognizing a sale-leaseback transaction as a real estate sale. However, IFRSs provides that the accounting for sale-leaseback transactions pertaining real estate is not different from that involving non-real estate assets.

Changes and Challenges in the Lease Accounting Debate

The current accounting system for leases provide the lessees and lessors should categorize their leases as either capital or operating, and recognize them separately. As a matter of fact, firms apply classification tests to establish the appropriate accounting resulting from leases. Users of accounting information have criticized the existing accounting model for operating lease because of failure to satisfy the needs of financial statement users based on the faithful representation of leasing transactions (Beckman, 2016). Therefore, stakeholders have requested for to transform accounting procedures that allow recognition of assets and liabilities resulting from leases.

A joint project by FASB and IASB proposed various changes concerning guidelines for lease accounting under FASB 842 and the IASB exposure draft for leases. The new suggestions aim to enhance the quality as well as comparability of financial statements by giving significant transparency about operation assets, risks related to the lease, and leverage ratios.

One of the proposals in FASB 842 is off-balance sheet treatment of lease assets rather than purchasing them immediately. Under the current model for capital leases, lessees account for lease assets and liabilities on the balance sheet. However, lessees do not recognize assets and liabilities on the balance sheet. The new proposal will allow lessees to recognize assets and liabilities for the rights and commitments for leases operating twelve months or more. Bramwell (2013) FASB 842 may encourage some lessees to opt for short-term leases of less than twelve months or structure lease contracts as service agreements. Such as shift would result in a modest negative for lessors because short-term leases reduce the predictability of cash income for a lessor and minimized flexibility of the funding period.

The quality of decision-making would also increase under the new rule. For instance, it would enhance the level of management judgment applied by lessors to establish assets and discount rates. Similarly, additional disclosure about the residual value as well as interest rates used in calculations improves analytical comparison of issues. However, the proposed changes in FASB 842, it may be challenging to compare lessors who have different business or asset types. Lessor accounting may also become more complex because both income statements and balance sheet will need various changes to explore the true worth of the business. Without forgetting, lessors will require incurring extra expenses to analyze, establish, and maintain the new accounting standards (Lightner, Bosco, DeBoskey, & Lightner, 2013). In as much as players expect the costs to be reasonable, it would still be disadvantageous to the small-scale lessors whose margins are relatively small. The good news is that the lessors have time to make necessary implementation mechanisms because the new rules in FASB 842 will be effective from 2017.

Harmonizing the gap between GAAP and IFRs through Conceptual framework

GAAP and IFRs guidelines concerning lease accounting have some significant differences, which does the joint project by the two standard bodies critical. In as much as conceptual framework is not an IFRs nor IASBs, it provides a firm basis for the preparation and interpretation of financial statements. Under the existing model, IAS 17 treatment of operating leases contrasts the definition of assets and liabilities in the conceptual framework. Therefore, it makes it difficult for accountants preparing financial information, which in turn creates hurdles for users to interpret financial information correctly.

Ideally, the primary objective of financial statements is to supply valuable information users such as shareholders, potential investors, creditors, lenders and others to enhance the quality of their decisions (Pacter, 2016). If the application of lease accounting guidelines posited under IFRs and IAS does not promote faithful representation of information, then financial statements become irrelevant decision-making tool for the users. Therefore, it misses the core purpose of financial reporting due to material error transfer.

Understandably, useful information should be relevant and faithfully represent what it claims to represent. The relevance of information roots from the fact that it can influence the decisions users to make while accurately represented information should be complete, free from error, and neutral (Ball, 2013). Therefore, conceptual framework concerning lease accounting should enhance completeness and neutrality of financial information irrespective of whether users apply IAS or IFRs.

Moreover, comparability of a financial information improves its quality. For example, users should be able to use financial information provided to compare financial statements between reporting periods, companies, or industries (Brochet, Jagolinzer, & Riedl, 2013). However, the current lease accounting model gives broad scope for omitting material information by allowing treatment of same information in different ways. It also arranges lease contracts that allow companies to achieve financial position they desire rather depicting the actual picture, which destroys comparability characteristic of the financial statement.

In summary, the conceptual framework project will harmonize the differences between IFRs and IASB to establish a common reference point just in the standards are not satisfactory. It would increase transparency, understandability, and comparability among recognitions of lessors and lessees. Disclosing significant information on the balance sheet concerning leasing arrangements improves the usefulness of the fiscal reports.

Proposed Solutions

Current lease accounting model fails in offering a complete definition of assets and liabilities, which makes it difficult to classify leases as either operating or finance. I think one of the proposals that should be included in the conceptual framework or improvements is to consider substance transaction rather than its legal form. For instance, general understanding of asset is a resource that an entity controls, whose value may be influenced by past events, and that results into future cash flows. On the other hand, liability refers to present obligations of an entity whose value may depend on past events and may influence future cash flow. A lessee enters into a contract to gain the right to utilize an asset under a given period, which presents an obligation to the lessee. Therefore, a lessee must ensure economic benefits flow from the entity to settle the obligation. However, IAS 17 provides that future payments for an operating lease be disclosed in the footnotes section of the financial statement without disclosing the present values the lessor charges. Hence, no liability exists in the financial statement even though an obligation to settle the lease exists. Apparently, without recognizing all the assets and liabilities arising from a lease agreement, relevant information does not reach the users (Churyk, Reinstein, & Lander, 2015). In another perspective, the model gives accounting information preparers power to conceal relevant information related to lease transactions.

Additionally, FASB can make temporary adjustments to remove operating leases categorized only to avoid capitalization. FASB could add a classification system that capitalizes leases where the lesser has both upside and downside risks in the residual lease. For instance, IASB had to propose an exposure draft before improving IAS 17 in 1999.

Bible Verse

I think the Bible verse that best explains leasing as a business practice is Mathew 21: 33-46. The verses tell the parable of the tenants where a landowner planted a vineyard, fenced it, built winepress, and watchtower in it. The landowner then rented the vineyard to farmers, transferred the control obligation, and relocated to another place. During harvest time, the farmer sent his servants to the farmers to collect his fruits. However, the farmers beat and killed the servants. The tenant sent another group of servants and later his son, but all dies in the farmers’ hands. Jesus then said that when the tenant came, he evicted the farmers and rented the vineyard to other farmers who could give him a share of the crop at harvest time. Jesus was comparing the Kingdom of God with the farm by saying that God will give it to the people who will produce its fruits.

Based on the above parable, the landowner is the lessor who rents it to the farmers (lessee). Just as a typical lease agreement, the lessee is supposed to give the lessor regular payments within a specified period. In the above parable, the farmers (lessee) did not owner their end of the bargain thereby making them breach contract. Therefore, the vineyard owner had the right to evict them and rent it to other farmers who can give him part of the returns. Jesus says that God will give His kingdom to people who produce fruits. Even in typical lease agreements, lessor will only commit to an arrangement that guarantee him or her regular payments. Therefore, if there were IFRs and IASB standards in the parables case, the farmers or the tenant would have followed them to resolve the conflict rather than killing. Importantly, the parable confirms the importance of having clear IFRs, IAS, and conceptual framework to resolve cases involving leasing transactions because lack of them can cause anarchy.