Magazine article The RMA Journal

Capitalizing Operating Leases: A Banker's Perspective: FASB and IASB Have Proposed Major Changes to the Way Lease Obligations Are Accounted for, with the Goal of Increasing the Comparability of Financial Statements. but While the Changes Are Appealing in Theory, Their Impacts Could Be Negative

Magazine article The RMA Journal

Capitalizing Operating Leases: A Banker's Perspective: FASB and IASB Have Proposed Major Changes to the Way Lease Obligations Are Accounted for, with the Goal of Increasing the Comparability of Financial Statements. but While the Changes Are Appealing in Theory, Their Impacts Could Be Negative

Article excerpt

THE FINANCIAL ACCOUNTING Standards Board (FASB) and the International Accounting Standards Board (IASB) are working toward the convergence of the world's two prominent accounting standards: U.S. GAAP and IFRS. The goal is a singular global accounting standard that will create comparability of financial statements across the world.

The FASB and IASB jointly issued a series of exposure drafts in 2010 and 2011 that propose monumental changes to the way lease obligations are accounted for. The primary goal is to bring a significant source of conventional financing onto the balance sheet, thereby increasing the comparability and transparency of the financial statements. While the overall debt obligation of each financial entity will be displayed in a more complete presentation, this proposed accounting regulation will result in additional costs, reduced efficiency, and manufactured uncertainty for the primary users of the financial statements.

Balance Sheet Presentation

Currently, U.S. GAAP classifies certain capital assets by the method of finance related to the specific asset. The basis of this ideology lies in who owns, or will own, title to the asset. Traditional loans are extended to borrowers for the purpose of purchasing title to an asset. As a result, assets acquired using traditional loans require capitalization of the long-term asset and recording of the corresponding liability, broken out between current and long-term portions on the borrower's balance sheet. Capital and operating leases are extended to lessees in order to purchase the right to use an asset, as opposed to purchasing title to the asset itself.

In an attempt to prevent potential abuses of this financing type through transaction structuring, U.S. GAAP stipulates four bright-line tests to identify transactions that are, in essence, a purchase rather than a lease. Transactions, which are in substance a conditional purchase, are treated as a capital lease. A lease that meets any of the following is a capital lease: 1) the present value at the beginning of the lease term is greater than or equal to 90% of the fair value of the leased item, 2) ownership of the asset transfers to the lessee at the end of the lease term, 3) the lease contains a bargain purchase option, or 4) the lease term is equal to 75% or more of the estimated economic life of the asset. Capital leases and traditional loans are accounted for similarly.

Operating lease payments are expensed instead of recorded as a payment of a liability, and the corresponding lease obligation is excluded from the balance sheet. Instead of a balance sheet presentation, operating leases result in footnote disclosures to the financial statements. While operating lease obligations have always been considered a large source of off-balance-sheet financing, the recent economic downturn, the accounting standards convergence initiative, and the complexity of the current regulations have prompted action by regulators to revisit the existing accounting regulations for leases.

The FASB and the IASB have developed and issued an exposure draft that would fundamentally change the way operating leases are accounted for. Instead of classifying certain capital assets by the method of financing, assets would now be defined by their use. As mentioned previously, the proposal would change the basis of classification from the question "Who owns, or will own, title to the asset?" to "Who has the right of use of the asset?" This ideology professes that any tool of production used by an entity is, in functional reality, an asset and should be accounted for as such.

The result is that there will no longer be a classification difference between "capital" and "operating" leases. All leases will be subject to the same accounting treatment as capital leases are treated currently. In essence, operating leases would cease to exist. An asset will be recognized to record the lessee's right to use the leased property, and a corresponding liability will be presented for the obligation of the lessee's future payments over the initial lease period and any likely lease extensions. …

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