Amongst the various sources of finance, like sale of financial instruments, or even borrowing loans from banks and other financial institutions, a very popular method is lease or lease financing, that is defined by the Leases Exposure Draft of the International Accounting Standards Board (IASB) & Financial Accounting Standards Board (FASB) as “a contract in which the right to control the use of a specified asset (the underlying asset) is conveyed to a customer, for a period of time (throughout the lease term), in exchange for some consideration (periodic rental payments), if the customer has the ability to direct the use, and receive benefit from the use” (FASB, 2012). Here, the right to use the specified asset is granted by its owner (lessor) to the customer (lessee). Further, “the specified asset is explicitly or implicitly identifiable, such as a piece of land, building, equipment or machinery. However, a capacity portion of a larger asset that is not physically distinct, such as the capacity portion of a pipeline, is not a specified asset” (FASB, 2012).
The accounting treatment of lease transactions depends on their classification, which according to the current lease accounting standards “categorizes them as capital lease and operating lease, with the former transferring complete ownership of the leased property to the lessee at the end of the leased term, which is usually for most part of the economic life of the asset, thereby, subjecting him to all the risks and rewards of ownership during the lease term” (New York University, n.d.). This makes the lessee recognize the leased property in his books, both as an asset (for transfer of complete ownership) and a liability (for lease payments). Whereas, the latter involves transfer of only the right to use the leased property by the lessor to the lessee, who neither bears any risk nor enjoys any benefits, and therefore, treats the lease payments as an operating expense in the income statement, with no record in the balance sheet, thereby, “resulting in an off-balance sheet financing with regards to the operating leases” (Seay & Woods, 2011), “often painting a distorted picture to the users of financial statements, devoid of complete depiction of the parties involved in the leasing transactions since there is no concrete knowledge about the either one’s rights and obligations corresponding to the assets they own or the liabilities they owe” (IFRS Foundation, 2010). The “inability of GAAP to distinguish between both the leases using bright-line tests, has only worsened things by permitting small manipulation in lease terms to achieve a desired reporting outcome, thereby, resulting in different accounting treatments of economically similar transactions, and causing the problem of inter-organizational incomparability” (Seay & Woods, 2011).
“The boards (IASB & FASB) on August 17, 2010 issued the initial exposure draft suggesting a solution in the form of a new accounting paradigm for all leases” (Seay & Woods, 2011), regardless of their type, using right of use model or Approach A which would make it imperative for all leases to be shown both as assets and liabilities in the books, while, replacing bright-light tests with principles-based accounting thereby, making financial reporting more holistic and comparable in nature. However, “in 2012 with the involvement of the U.S. leasing trade body, the Equipment, Leasing and Finance Association (ELFA), that showed preference for using straight-line cost method for operating leases to better reflect the lease’s economic effects on the lessee’s financial statements, especially in case of equipment and real estate lease, the boards have started debating on the final four lease accounting methods including the earlier mentioned “right of use model”, namely; interest-based amortization model or Approach B which amortizes the leased asset based on the timing and amount of rental payments along with the assumed benefits realized from it; underlying asset model or Approach C, which amortizes the right of use (ROU) asset based on the lessee’s estimation of the decline in the fair value of the underlying asset throughout the lease term; and whole contract model or Approach D, that accrues the average rent as the reported lease cost on the lines of the U.S. GAAP, adjusting the ROU asset and lease liability on each balance sheet date to be the present value of the remaining lease payments” (Collinson, 2012). But, a final decision is pending and not likely in the offing “before 2013, after the revised exposure drafts are issued in the fourth quarter of 2012” (McGladrey LLP, 2012).
This argumentative essay tries supporting the boards’ proposed solution of accounting all leases using the right of use approach in order to not only make the financial reporting process complete and comparable, but also objective and transparent by discouraging manipulation of the lease contract terms by the lessees in their favor, and tries adhering to the following structure of discussion:
Background
“The flexibility leasing accords to both the consenting parties to share risk under a contractual agreement makes it a popular source of finance for many sectors of the economy (Hepp & Scoles, 2012)”. This is confirmed by its “annual volume of $760 billion in 2007, as estimated by the World Leasing Yearbook 2009” (Knubley, 2009). However, the criticism surrounding its accounting dichotomy that till now tended to be easily abused by the lessee for his own benefit, as previously discussed, forced the boards’ to come up with a single right to use model that considers all leasing transactions as being financial, instead of operational, and “views the underlying asset in the transaction both as a receivable for the present value of the future minimum lease payments and a residual lying with the lessee which he is obliged to return to the lessor after the lease term ends, thus, making the lessor immediately recognize profit from the portion of the underlying asset transferred to the lessee, and generate value from it, that too with the option of retaining or not retaining the residual risk by either lease financing a new asset or remarketing of the old used one” (Hepp & Scoles, 2012).
But this new proposed model is not indiscriminately applicable to all lease contracts. For example, “lease contracts with sale or purchase arrangements involving biological assets under IAS 41, marked to market lessor investment properties under IAS 40, and also leases of intangible assets like patents, software, licenses along with leases to explore minerals, oil, natural gas etc. are exempted from this new standard or model” (Seay & Woods, 2011).
Although, the proposed changes stem from the existing problematic accounting treatment of operating leases that benefit the lessees’ financial statements, but using it for lessors’ would be somewhat inconsistent with the suggested approach to lessee accounting, thereby, including the discussion about both lessee and lessor accounting in the new exposure draft.
Comparison of Existing Lease Accounting Models
As mentioned previously, the boards currently are debating on the best accounting model to be used in treatment of the leases, and are caught amidst a decision dilemma centering around the four approaches of right of use model (Approach A), interest-based amortization model (Approach B), underlying asset model (Approach C) & whole contract model (Approach D). All these approaches differ not only with respect to their economic impact of the lease transaction on the lessee’s financial statements but also the complexity involved in calculating them that also affects their accuracy.
“For example, the rate of amortization of the leased asset under Approach B is the same as the debt amortization rate, and the method creates a straight-line cost pattern only if the rental payments are uniform throughout the lease term. Further, it is definitely a complex computation involving estimates.
Similarly, Approach C is also equally complex for the lessee to make, especially, if the residual value of the asset upon the expiry of the lease term is different from its fair value at lease inception, a condition which is mostly the case in real estate leases but not equipment leases, and also an important prerequisite to create a straight-line cost pattern.
Whereas, Approach D, first of all has no scope to consider a lease transaction as being financial in nature, because it, from the time of lease inception to lease expiry views a ROU asset not only distinct from the other non-financial assets and the underlying asset itself, but also inseparably linked to the lease liability” (Collinson, 2012).
“However, despite the above dissimilarities, the main difference amongst them actually lies with respect to the structural aspects of their presentation and disclosure in balance sheet, income statement, cash flow statement and notes accompanying the financial statements of the lessee, whereby, all of them normally require him to separately present on the balance sheet, both ROU asset and lease-payment liability. Still, some conditions may also necessitate disclosure of rent paid asset & rent payable liability, while using Approach D.
Further, moving onto the income statement we find differences in the treatment of lease expense in Approaches A, B & D, with the first approach including the time-value accretion of lease payment liability as a single interest expense item, represented as the total of both lease and non-lease interest/financing expenses. Not only this but the utilization of the ROU asset is presented as a single amortization expense item, that manifests itself as a sum total of both lease and non-lease amortization expenses, including depreciation expenses also. While the next two approaches; B & D separately present the lease expense, with it being disclosed as single line item, and consisting of the net-total of the time-value accretion of the lease payment liability, the time-value accretion of the ROU asset and expiration of the ROU asset.
Even in preparation of the statement of cash flows using the indirect method, under the Approach A, the Operating Section would see an addition for Amortization Expense and a reduction for an excess of Interest Expenses over cash lease payments made. Similarly, the Finance Section would see a reduction for an excess of cash lease payments made over Interest Expenses. Likewise, the Operating Section under Approach B would have an addition for the amortization element of the lease expense, and a reduction for any excess of the interest element of the lease expense over cash lease payments made, whereas, the Financing Section would witness a similar decrease for any excess of cash lease payments made over the interest element of the lease expense. However, in case of Approach D, the Operating Section would see a reduction for any increase in Rent Prepaid Asset & decrease in the Rent Prepaid Liability and an addition for any decrease in Rent Prepaid Asset & increase in the Rent Prepaid Liability” (Pounder, 2012).
Besides, the approaches have their own share of practical and conceptual advantages and disadvantages, as revealed by the IASB/FASB outreach meetings in February and March 2012. “The boards opined that the interest-based amortization model, though involving complex calculations, is still simpler in most cases, but at the same time provides an experience of amortization, typically different from that of property, plant and equipment.
Whereas, the underlying asset approach, though appeared more conceptually sound to the boards, but is also not free from a great deal of subjectivity surrounding the determination of the expected expiry of the asset at the end of the lease term, which is an odyssey for the lessee to arrive at, auditor to audit and the preparer to implement” (Smith, 2012).
Further, “the unusual method of arriving at the net asset figure both under the interest-based amortization model and the whole contract model also made the auditors question the approach to be adopted in testing and accounting for the impairments under each. Even the users were of the opinion that a single model for all leases would be the best, since they themselves currently try capitalizing the lessee’s operating leases in order to get a better indication about the company’s financial position, thus, signaling an increased importance accorded to uniform financial reporting process, and also actively voicing their preference for either the right of use or whole contract model” (Smith, 2012).
Why “Right of Use” Model?
The dialogue so far definitely confirms the stakeholders’ strong intention to have a much simpler, uniform and transparent financial reporting process by eliminating the current accounting treatment of operating leases, that is benefitting the lessee and hurting the lessor, by allowing the former to restructure the lease agreements in his/her favor and show the same as a favorable outcome in the books, thereby, also swaying the boards’ inclination towards the adoption of the right of use model that apart from removing this problem, will also offer many other benefits that will not only pacify the aggrieved lessor, who is an equal party in the entire transaction, but also revamp the entire financial reporting process, and accord more transparency and completeness to it.
According to Seay & Woods (2011) (as cited in FASB/IASB, 2010) the proposed right of use model is more aligned with the FASB’s Conceptual Framework definition of the lessee’s asset as being an underlying and an intangible one, that has the right to be used only till the lease term, in contrast to the current lease accounting rules that define it using the financing method. As a result, the lessee who originally records the asset at the present value of the lease payments would see it amortized over its economic life or lease term, whichever is shorter, “forcing him to not only recognize the amortization expense on it, but also the interest expense on the lease liability on the income statement” (Valles, 2010). Further, even in the balance sheet the said asset would be disclosed as belonging to the property, plant and equipment category, without being a part of owned assets. Regarding the lessee’s payment liability, the new model would determine it using the rate charged by the lessor, while also considering contingent rentals and expected payments under term option penalties, a feature currently missing in the existing accounting rules. This would, of course take into account the present value of the lease liability (minus executor costs), lease term and any residual guarantees.
The lessor on the other hand, based on his risk/benefit exposure, would also be comfortable getting an option to either “recognize the right to receive future lease payments as an asset that remains recorded on the lessee’s books, if he (lessor) is exposed to the underlying asset’s risks/benefits, thereby, making him (lessee) obligated to continue performing the process of making the payments (performance obligation model), thus, making it possible for him (lessor) to record both the right to receive lease payments in his books, as a liability of the lessee to use the underlying asset throughout the lease term or derecognize (de-recognition model) i.e. take of a part of the underlying asset off the balance sheet, due to some significant portion of the risks/benefits already transferred to the lessee in the lease arrangement, making him bound to make future lease payments, thereby, granting him (lessor) the right to receive them and record the same in his books” (Seay & Woods, 2011).
The right to use model gives another breather to the lessors’ by keeping their financial ratios intact by deferring its impact on them till the issuance of final guidance by IASB/FASB. Moreover, the good news is that “the new accounting model warns only the lessees of significant changes in their accounting ratios, while listing down the following prominent financial health indicators most likely to be impacted” (Seay & Woods, 2011):
Liquidity Ratios: The most important liquidity ratio to be affected by the new model would be the current ratio that would decrease, based on the current portion of lease liability in the lessee books.
Leverage Ratios: The lessee would also witness an overall impact on his debt load and the debt-equity mix, as highlighted in his leverage ratio. The prominent ratios to be impacted would include debt ratio, which would rise as the new model would make it mandatory for both assets and liabilities to be furnished in the financial statements. Therefore, “lessees with huge amount of leases such as an aviation company would be forced to record both assets and liabilities in their books according to the lease term” (Ma, 2011), resulting in enhancement of their balance sheets by the same amount, and an increase in their debt ratio. Further, since the new standard already diminishes the demarcation between capital and operational leases and makes the lessee record the lease transaction both as an asset and liability, therefore, it automatically triggers both an increase in his debt in the form of lease payments to be made, and a decrease in equity (cash), thus, having a cumulative impact of increasing his debt-equity ratio. The impact does not end here, with the lessee’s “interest coverage ratio also suffering on account of increase in interest expense due to expense recognition on leases that were previously accounted as operating leases which the new model would make front-end loaded” (Ma, 2011).
Efficiency Ratios: The lessee’s overall efficiency ratios primarily indicate the productivity of an organization by using its assets’ performance to generate net sales would also take a beating, as reflected in a low asset turnover ratio figure due to a bolstering asset metric in the balance sheet against stagnant or decreasing net sales figures.
Profitability Ratios: Finally, the new model appears unsparing even to the overall profitability of the lessee with a stagnant or decreasing net sales giving way to a lower net income figure in the face of ever increasing assets amount recorded in the balance sheet, thus, translating into a low ROA figure. Moreover, as already mentioned, a dwindling cash amount due to lease payments, along with a lower net income figure coupled with no change in net sales would ultimately also start eating into the lessee’s overall profit margin and ROE figure, both of which would also see a decline.
“According to Valles (2010) (as cited in Miller & Bahnson, 2010), the new exposure draft would immensely affect organizations which deliberately try keeping debt off their balance sheets using operating leases”. This definitely improves the previously unclear situation with regards to measuring both assets and liabilities, which now takes place “based on the longest possible lease term, that is more likely than not to occur, recognizing the effects of any lease extension or termination options, thereby using expected outcome techniques like contingent rentals and residual value guarantees specified by the lease, and is also updated through a subjective process that requires re-evaluation of the expected outcomes more likely than not to occur at each reporting date depending on any new facts or circumstances signaling a significant change” (Seay & Woods, 2011). This aptly communicates to the users of financial statements as to what constitutes rights and obligations of both the parties involved. Moreover, “the right to use model has facilitated sound decision-making by investors, creditors and other users of financial statements, which according to FASB’s Conceptual Framework, is the sole purpose of financial reporting. This is evident from the feedback received by the boards’ from a majority users, dispersed both geographically and sector-wise including The International Working Group on Lease Accounting, auditors, accountants, users and preparers of financial statements, most of whom have clearly cited increased accuracy, greater trustworthiness in representation and improved inter-comparability amongst different entities as significant milestones reached by this new model, with particular ones being, putting an end to the users’ job of adjusting to operational lease information or relying on such subjective judgments made by analysts using estimates, and also making them better informed about the expected future cash flow position by including the influence of contingent features and amounts payable in optional time periods in the lessee assets and liabilities” (Seay & Woods, 2011).
If the findings of a paper that appeared in the International Journal of Economics and Finance are anything to go by, then this proposed new model is even tax-friendly for both the parties. “The said paper looked into the accounting and tax implications of buying or leasing an asset in Hong Kong and found that if the finance rates on a borrowing and lease are same, then a tax payer would benefit more by buying the asset, since it would allow him/her to enjoy tax benefits through high depereciation allowances, whereas, if the tax payer is not subject to tax, he will be better off leasing the asset, and consequently, the tax benefits enjoyed him can then be passed on to the lessee as reduced rental” (Ho, Kan, & Wong, 2010).
Moreover, the new lease accounting standard has important economic implications too. “In contrast to the existing U.S. GAAP that does not furnish the assets and liabilities in a particular lease transaction on the lessee’s balance sheets, the right to use model would be the first in itself single accounting model imposed on all leases, which initially, would enhance the assets-liabilities figures for both current and previously carried out lease transactions, classified as operational leases, thereby, helping the income statement get rid of reflecting the rent expense using straight-line method, and instead show amortization of the leased asset and interest expense using the effective interest method” (Seay & Woods, 2011), “giving rise to a front-loaded lease expense pattern of profit or loss i.e. during the initial years of the lease term, the lease expense recognized would surpass the lease payments received, and during the later years, this trend would get reversed” (KPMG, 2011). Further, “the estimated future lease (rental) payments would be determined uisng the net present value of the leased asset and the present value of those lease payments plus the initial direct costs will be the new lease asset” (Ma, 2011), thereby, resulting in more accurate cash flows as the time value of money would be used to assess long-term projects.
However, even the above mentioned words of praise could not stop the staunch critics who have already started digging on the proposed standard even before it sees the light of the day, by questioning its cumbersomeness “in terms of requiring huge calculations using both currently and historically available data to precisely arrive at the estimate lease term, thus, making it a time consuming exercise” (Ma, 2011), demanding a dedicated team of experts, and also “casting doubts on its efficacy in protecting the interests of the lessor, by actively pointing towards the complexity that surrounds the estimation of contingent rental lease payments and lease term that are sufficient to create a chaotic level of volatility in both profit or loss, thereby, admonishing the lessor accounting model for providing information that appears too costly to obtain under the new model in comparison to the overall benefits it offers,” (Ma, 2011). For example, in case of hotel industry, predicting the net year’s sales is in itself a daunting task; leave aside trying to ball-park rental payments of a 10-20 year lease terms, which are both unpredictable and also subject to a wide variety of potential estimates. “Even the comments received on the exposure draft view the relevance of the proposed rules from the economic standpoint discussed above with a skeptical eye, opining that because the estimated payments from lease renewals and contingent rents fail to meet the definition of liabilities, therefore, they should not be capitalized” (Ma, 2011). But, despite these weaknesses, we vote for the new model that apart from providing many benefits, tries bringing uniformity in assessment of all lease transactions to the door-step of the financial world, and, thus, make the financial reporting process comparable among industries and organizations, which in turn would also serve to improve the capital market efficiency” (Valles, 2010).
Conclusion
The above discussion definitely serves as an eye-opener with respect to the latest happenings taking place in the finance and accounting world, particularly with active reference to the leasing industry, which in itself is supposedly a potent source of raising funds for many sectors of the world economy. At the same time, the argument also brings to light the malicious role of the lessee, who ridden by greed and ambition often uses one category of leasing arrangements, the operating lease for his own personal benefit by manipulating the terms of the contract to reflect a desired reporting outcome, that takes the aggrieved lessor on ransom, thereby, assigning an altogether different meaning to an otherwise contractual agreement originally devised with an intention to provide a flexible and legitimate means to satisfy the financial needs of both the consenting parties, while allowing equal sharing of risk without any extra burden on either of them.
However, amidst all this chaos, the proactive efforts of the IASB & FASB towards devising a common accounting approach in the form of “soon to come” right to use model that serves to blur the demarcation between both capital and operating leasing agreements has also been discussed at length, which indicates a likely end to the lessee’s abuse of the lease contract and his exploitation of the lessor in the near future, and therefore, does represent a silver lining in the cloud, which according to the industry insiders would not only appease the lessor but also rectify the current anomalies in the financial reporting process.
Even though, the proposed model in its nascent stage has met with strong criticism, still, going by history, that is replete with examples of increased quantity of both supporters and critics of every initative or step taken in all spheres of life, we recognize it as one such change initiative taken, which like its predecessors won’t be able to satisfy everyone, and therefore, see wisdom in ignoring its drawbacks for the time being, and only focusing on the “big picture” of the attainment of a uniformly transparent financial reporting process full of satisfied stakeholders, by leveraging its (the model’s) benefits.
References
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