International Corporate Reporting Lease Accounting

Impact On Decisions Of Users Of Financial Statements


Essay, 2011

11 Pages, Grade: 1,0


Excerpt

Table of Contents

1. Introduction

2. Current lease reporting and the future
2.1 The impact on decisions of users of financial statements
2.2 The Boards’ proposed model and its impact

3.Discussion & Conclusion

4. References

1. Introduction

The lease accounting model of IAS/IFRS and US-GAAP has not changed since 1976 and has continually met with criticism. In particular the distinction in operating and finance leases considering that there are only small differences and the lack of taking into account of liabilities and assets, related to operative leases, on the balance sheet of the lessee have been the subject of much criticism. Therefore the International Accounting Standards Board (IASB) has published a discussion paper in 2009 and the exposure draft Leases in 2010. The IASB and FASB attempt to modify the basic form of lease accounting in mid 2011.

Lease accounting is important. The volume of lease transactions in the U.S. is nearly estimated at several trillion dollars whereby the majority of lease obligations are off balance sheet (Ernst & Young, 2010). In Europe the total leasing market in 2009 conducted € 209,352.6 millions (Leaseurope, 2009).

This paper has the objective to analyse the relationship of the current and the proposed model of lease accounting and the decision-making process of readers of financial statements who can be managers, investors, financial auditors but also a big range of stakeholders. Initially, the impact of lease accounting and its’ issues on financial statements will be examined. In the second part the changes, evolved from boards’ proposal, to firms’ balance sheets will be analysed in terms of their influence on the financial statement user’s decision and the impact on businesses. According to the known weighty numbers of leases in Europe and the U.S. a change to a lease standard could have enormous outcome.

2. Current lease reporting and the future

2.1 The impact on decisions of users of financial statements

In order to answer the question to which extent the current lease accounting has impact on decisions of users of balance sheets, initially we need to have a look on the purposes and objectives of financial statements. In this respect financial statements have the objective to “provide information about the financial position, performance, and changes in financial position of an entity that is useful to a wider range of users in making economic decisions” (Mirza, Holt and Orrell, 2006, p.7). In order to achieve those objectives financial statements provide information about an entity’s assets, liabilities, equity, income and expenses, contributions by and distributions to owners and also cash flows (Kirk, 2009). Thus we can see that financial statements have significant influence on users of balance sheets and because companies report their leases, there also exists a tie between lease accounting and the decisions of users of financial statements. To discover the amount of the impact of current lease accounting on the quality of the financial statements we need to analyse the major issues of lease accounting and their aftermath on the balance sheet.

Currently both IFRS and U.S. GAAP make a distinction between capital (finance) leases and operating leases whereby capital leases substantially transfer all risks and benefits of ownership from lessor to lessee. In this regard lessees have to recognise the leased property as equity and the obligation for future payments as liability. At the same time operating lease is not recognised on the balance sheet of the lessee neither as equity nor as liability (Pounder, 2009). Therefore a respectable amount of assets and liabilities does not appear on the balance sheets of lessees.

Kane (1991) explained how lease types affect financial statements. According to that, under a capital lease a company is not renting equity but rather purchasing through periodic payment rates. As mentioned before the organisation hast to list the property as an asset and the obligation to pay the instalments as a liability. Hence, a capital lease increases the debt-to-equity ratio, which is a commonly used ratio. Furthermore a capital lease will have impact on an organisation’s income statement because both interests on liabilities regarding the lease and property depreciation have to be listed as costs. On the other hand operating leases do not appear on a balance sheet as an asset nor do the instalments associated with the lease appear as liabilities. This means that under operative leases the assets and liabilities are not reflected through the debt-to-equity ratio. Kane (1991) finally concluded that for an organisation it depends on the right distinction between finance and operative leases to evaluate the influence on its financial statements.

Valletta and Huggins (2010) researched the implication of the current lease accounting model on balance sheets of hospitals and found that it leads to a distorted image of reality. Thus, hospitals can appear less indebted than they really are. Besides their research has shown that the proposed accounting change would increase the interest-bearing debt reported on the average company’s balance sheet by about 58 per cent. Therefore Valletta and Huggins (2010) argue that there is a need for change to ensure greater transparency in off-balance obligations. With regard to the objectives of financial statements, information about an entity, which appears less indebted than it really is, would most likely lead to a wrong economical decision.

Obviously the current lease accounting model has influence on the assets and liabilities reported on firms balance sheets. Thus there must be a strong tie between the current lease accounting standards and financial ratios. Ingberman, Ronen and Sorter (1979) analysed the effect of lease capitalisation under FASB statement No. 13 on financial ratios. The authors found that the capitalisation of leases decreases working capital by the current ration of lease obligations. The authors also stated that capital leases increase long-term debt without an influence on equity, which leads to a larger debt-equity ratio for capital lease firms than operating lease firms. In addition they stated that capital leases could increase operating income by the difference between the lease instalments and depreciation of the property. Finally, the authors conclude that the FASB statement No. 13 has a subtle impact on financial key ratios. Thus, there is a certain complexity in understanding financial statements.

When we summarise the major criticism on lease accounting we come to following findings. Thus first, it can be hard for organisations to distinguish between operating and finance lease due to the fact that it is laborious to define the dividing line between capital leases and operating leases. Second, operating lease accounting fails to recognise a contractual liability and the related acquisition of assets. Third, operating lease disclosures do not provide readers of financial statements with sufficient information to let them realise the effective amount of related assets and liabilities. Further critique indicated that the current guidance allows the creation of lease contracts to achieve certain accounting treatments. Consequently the current lease accounting standard offers opportunities to structure transactions so as to achieve a certain lease classification (Kuczborski, 2010; IASB, 2009).

2.2 The Boards’ proposed model and its impact

The new proposals, issued by the IASB and FASB, adopt the so-called right-to-use approach to lessee’s accounting, which differs on principle from the current model. The boards’ believe that the right acquired by the lessee in a lease contract is the right to use the leased property during the lease term. On a broader front, that right meets the IFRS’s definition of an asset and further the obligation related to the leased property meets the IFRS’s definition of liabilities. That means a lessee would always list an asset and a liability on the balance sheet under the new standard (Holt, 2010).

Concerning the elimination of operating leases firms will be required to convert their operating leases to capital leases. Grossman and Grossman (2010) explored the effect, evolved from the conversion of operating leases to capital leases, on both current and total liabilities of 91 chosen companies, taken out of the top 200 of the Fortune 500 list. The results have shown that for the bigger half of the companies there was an increase less than 5 % on both current and total liabilities. Besides, 37 % of the examined companies had an increase of 10 % or more in total liabilities and 15 % of the examined companies had an increase of 10 % or more in current liabilities. Three companies even had significant increases in current liabilities ranging from 23 % - 30 %. As the figures have shown the increases in liabilities would have significant impacts on the balance sheet and further more on financial ratios.

Pounder (2009) also stated the effects of the new lease accounting standard on the lessee’s balance sheet. The rising not only of assets but also of liabilities would have an impact on leverage ratios such as debt-to-equity. In addition there are effects on financial performance measures. Under the new standard the lessee will recognise interest expense, depreciation and expense for executive costs and will disregard rent expenses. This will lead to a higher EBITDA (Earnings before interest, taxes and depreciation) because rent expenses are deducted from it, interest depreciation are not. EBITDA is often used as a key figure to determine the amount of executive compensations or loan covenants.

Likewise, Pounder (2009) argues that the interest, depreciation and executive costs in total exceed the current rent expenses and therefore the lessee’s net income will be decreased. Thus the reduction in net income plus an increase in assets will lead to a lower return on assets ratio.

A survey of bankers in Canada who use financial statements to decide if they grant a credit has shown that bankers consider both capital and operating lease information. Yet, capital lease information that is on the balance sheet can be evaluated with the help of financial ratios and has therefore more influence on the banker’s decision than operating lease information, which is listed in the financial statements notes. Hence operating lease information gets less attention than finance lease information in the credit-granting process. The results of the survey demonstrated that a capitalisation of operating leases would have significant impact on key financial indicators of companies and on the decisions of capital providers (Durocher and Fortin, 2009).

According to a New York Times article by Satow (2010) the change of the lease accounting standard might lead to an increase of $ 1.3 trillion in leases on the balance sheets of U.S. companies. The new standard might debilitate companies in the eyes of investors. This also could have negative effects on the credit ratings of companies. Furthermore companies that are struggling under heavy debts in the moment will have to increase their liabilities under the new standard so their situation will become worse.

Leaseurope (2010), a body representing the European leasing industry, has constantly warned that the proposed lease accounting model will have huge impacts on businesses. The body announced the results of a survey of 125 European IFRS preparers conducted by PWC. According to the opinions of the respondents of the survey, EBITDA and leverage ratios probably will be most significantly affected. The consulted firms also affirmed a decrease in businesses’ net income. The leasing industry disagrees about the IASB’s opinion that the new proposal will reduce the complexity of lease accounting evolved from the distinction in operating and capital leases. Accordingly, lessees will have to make complex approximations regarding their lease terms and lease payments. These have to be reassessed each reporting year. Additionally, the have to make complex decisions whether a transaction is a lease contract or a service contract. Moreover, the survey has shown that more than 70 % of respondents believe that the cost of implementation will outrun any benefits.

When we briefly summarise how most leases would be affected by the proposal we come to the following findings. All leases will be listed on the balance sheet of the lessee because of the elimination of the distinction between capital and operating leases. Lease obligations will be re-evaluated at each financial statement date. The expense will be re-characterised as interest expense and amortisation instead of rent expenses. Furthermore financial ratios in particular leverage ratios will change for the worse. Yet, EBITDA will be more favourable (Ernst & Young, 2010)

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Details

Title
International Corporate Reporting Lease Accounting
Subtitle
Impact On Decisions Of Users Of Financial Statements
College
Manchester Metropolitan University Business School
Course
International Corporate Reporting
Grade
1,0
Author
Year
2011
Pages
11
Catalog Number
V184165
ISBN (eBook)
9783656087984
ISBN (Book)
9783656087793
File size
506 KB
Language
English
Tags
leasing, IFRS, Accounting, IAS 17
Quote paper
M.Sc. Thomas Loska (Author), 2011, International Corporate Reporting Lease Accounting , Munich, GRIN Verlag, https://www.grin.com/document/184165

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