This paper will outline the differences in accounting treatment of and criteria for determining whether leases should be accounted for as either a capital lease or an operating lease. I will be limiting my discussion to the accounting treatment of leases by the lessee.
This paper will discuss the current accounting treatment for the two types of leases according to Canadian GAAP and will tie in elements of the conceptual framework to the treatment of leases from CICA handbook section 1000, followed by a discussion on accounting theories related to lease treatment, and finally current issues outlined in academic research concerning lease treatment by the lessee. There are two major classifications of leases. Capital leases and operational leases.
A Capital lease is defined in the CICA handbook as “a lease that, from the point of view of the lessee, transfers substantially all the benefits and risks incident to ownership of property to the lessee” (CICA, 2010, Section 3065, ¶3). In order for a lease to be classified as a capital lease, the life of the lease must exceed 75% of the life of the leased item, there must be a transfer of ownership at the end of the lease or a bargain purchase option, and the present value of the lease payments must exceed 90% of the fair market value of the asset (Grossman, A.
& Grossman, S. , 2010). An operational lease is described by the CICA handbook as “a lease in which the lessor does not transfer substantially all the benefits and risks incident to ownership of property” (CICA, 2010, Section 3065, ¶3). It is very important for accountants to classify leases properly because the Accounting treatment differs for the two types of leases and the decision on which accounting treatment to use will affect a company’s bottom line.
As stated in the CICA handbook, a capital lease should be accounted for as an asset as well as an obligation. This means that a lease is both a benefit and a liability to a company (CICA, 2010, Section 3065, ¶15). The leased asset should be valued by calculating the present value of the minimum lease payment less executory costs which include things like maintenance costs, interest, and property taxes. If the executory costs cannot be determined, an estimation of these costs should be used.
The amortization period for the asset should be the period of expected use of the leased item and the accounting treatment should be similar to that of the lessee’s similar assets. If the leased asset is to be transferred to the lessee at the end of the lease, or if there is a bargain purchase option on the lease, which is an option for the lessee to purchase the leased asset at a price that is significantly lower than the fair value, the leased asset should be amortized during the period of the expected economic life of the asset (CICA, 2010, Section 3065, ¶3, 16, 17).
Lease payments reduce a portion of the lease obligation on the lessee’s books and cover executory costs. The lease obligation is only taken off the books of the lessee when the lease is fully terminated and or expired (CICA, 2010, Section 3065, ¶19). Operating leases are handled differently. Most operating leases are on a short term basis and do not account for a significant amount of the useful life of an asset. An operating lease is simply recorded as an expense on the income statement and a decrease of cash on the balance sheet of the company.
Operating leases are generally favoured by accountants for reasons discussed in further sections of this paper. The agency theory states that rational agents are those that are risk adverse, which means they try and stay away from risky ventures; self interested which means that they will base their actions on what will yield them the greatest benefit; and effort adverse which means that have a tendency to shirk and do as little work as they can in order to accomplish their main goals (Scott, 2009).
The agency theory is relevant when it comes to accounting for leases because if managers have compensation plans that are tied to net income, they will be tempted to manipulate the lease agreements so they may capitalize the lease rather than expense it so that the expense will not decrease their net income. Company owners must ensure that they are carefully watching the treatment of leases because this could mean the difference between a manager achieving their bonus or not.
The accounting treatment for leases can be easily manipulated by self interested managers. Another accounting theory that can tie into the accounting treatment of leases is the positive accounting theory. The positive accounting theory is defined in our textbook as being “concerned with predicting such actions as the choice of accounting policies by firm managers and how managers will respond to proposed new accounting standards” (Scott, 2009, p. 284).
We are concerned with predicting what managers should and ought to do when it comes to the implementation of new accounting policies. The positive accounting theory is relevant when dealing with lease accounting because as stated above, how a lease is recorded on a company’s financial statements can make the difference between an employee achieving their goals or not. It is important to be able to predict how a manager will react to changes in accounting standards.
If the change in accounting standards will have positive effects on the company’s financial statements, managers will be happy to implement them. However, if the changes in accounting policies will have negative effects on the company’s financial statements the opposite will be true. It is thus important to be able to predict what manager’s goals are and work at aligning those goals with those of the company.
The positive accounting theory states that managers will chose accounting policies that yield the least amount of risk for the company (Scott, 2010). Since debt is considered a type of shareholder risk and since lease obligations are considered to be long term debt, managers will be tempted to value the leased asset as an operating lease so they may expense the item instead of recording the asset as debt. This can be a very important issue for companies that have contractual obligations that limit the amount of debt they can have.
The CICA handbook states that “The objective of financial statements is to communicate information that is useful to investors, members, contributors, creditors and other users (“users”) in making their resource allocation decisions and/or assessing management stewardship” (CICA, 2010, Section 1000, ¶15). This means that the information provided in financial statements must assist the users of financial statements in making important decisions about a company. For example, providers of bank loans will be interested in seeing useful information (debt ratios) in the financial statements of the companies they are lending money to.
If companies that are seeking loans from financing companies cover up the fact that they have a long term lease obligation in order to increase their chances of receiving the loan, the company’s financial statements will not be useful for the users. Representational faithfulness is defined in the CICA handbook as being achieved when transactions and events affecting the entity are presented in financial statements in a manner that is in agreement with the actual underlying transactions and events (CICA, 2010, Section, 1000 ¶21).
A company’s temptation to perform off balance sheet accounting with their lease obligations to hide the fact that they have an ongoing obligation to make significant lease payments threatens a company’s representational faithfulness. In order for financial statements to be meaningful and useful to shareholders and investors, leases must be represented properly on the financial statements of the company who acquires the asset and must demonstrate true implications for companies.
If a company is given the choice between classifying a lease as either an operating lease of a capital lease, there is a huge risk to shareholders that the company will do so in order to benefit themselves rather than shareholders. It is very easy for managers to get derailed and falsify the true nature of leased items and for this reason, as described a little later in this paper, standard setting boards have proposed only having one classification for leases which forces all leases to be recorded as capital leases.
When accounting for leases, managers must also determine whether the lease will have characteristics to meet the definition of an asset to the company, which is defined by the CICA handbook as being “economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained” (CICA, 2010, Section, 1000 ¶29).
This means that if the leased item will transfer control to the lessee, transfer of control has happened in the past, and if the leased item will contribute future benefits to the company, the leased item should be classified as an asset and not simply expensed in the company’s income statement. Managers might however try and steer clear of recognizing their leased items as assets due to the fact that adding more assets to the balance sheet will increase the denominator in their return on assets equation which will in turn lower their return on assets.
In January 2011, Canadian GAAP will be replaced with International Financial Reporting Standards (IFRS). With the change from GAAP to IFRS there will be changes in the way companies account for leases (Pound, 2009). In this section I will highlight the differences between accounting for leases using Canadian GAAP standards and IFRS standards. I will also discuss suggested changes for accounting for leases stated in current research. Both Canadian GAAP and IFRS have different ways for categorizing leases.
In IFRS capital leases are still present, but are now called finance leases. Both capital and finance leases are those that transfer the benefits and risks of ownership from the lessor to the lessee. Under IFRS, finance leases are accounted for as financed sales of property much like in Canadian GAAP and are recorded as both an asset and a liability on the lessee’s balance sheet (Dunwoody, 2009). Standard setters have stated that there are many differences between accounting for leases in Canadian GAAP and IFRS.
First and foremost, unlike in Canadian GAAP, when determining whether a lease is a finance lease using IFRS standards, there are no quantitative thresholds, therefore companies must use more of their own judgement while making the classification. An added criteria for classifying a lease as a capital lease under IFRS is that the leased item can only be used by the lessee without making modifications to the item (Dunwoody, 2009).
Another difference between IFRS and Canadian GAAP is that under Canadian GAAP standards, if the lease is to be reclassified for example from a capital lease to an operating lease, there are strict guidelines as to how the consequences to the changes should be dealt with. Under IFRS standards however, there are no given guidelines for companies to follow when reclassifying their lease agreement (Dunwoody, 2009).
Contrary to Canadian GAAP standards, in IFRS, if the lease is classified as a financing lease, there must be an impairment test performed on the leased asset and a gain or loss must be recorded in the company’s financial statements (Dunwoody, 2009). The International Accounting Standards board and the Financial Accounting Standards board suggest that the distinction between a capital lease and an operational lease should cease to exist (Pound, 2009).
Many standard setters believe that since there is a temptation for companies to falsely classify their leased item as an operating lease due to off balance sheet financing in order to avoid a liability for the company. Another suggestion is to ensure that all leases are recorded on the lessee’s balance sheet as both an asset and a liability (Pound, 2009).
The IASB and the FASB believe standards should be changed because they believe that both operating and capital leases have the same economic substance and that if the lessee is granted the right to use a leased item that this meats the definition of an asset and their obligation to meet the payments of the lease terms meets the definition of a liability and thus should be recognized as an asset and a liability on the company’s balance sheet (Pound, 2009).
The IASB and the FASB believe that any rational manager, if granted the option to decide how to classify their leases, will do so in a way that will make the financial statements of the company appear as favourable as they can instead of presenting shareholders with the company’s true financial standing (Pound, 2009). Statistics show that 56% of CPA’s believe that all leases should be recognized as a capital lease and should appear on the balance sheet as an asset and a lease obligation (Shough, 2010).
As you can see from this statistic, there are mixed emotions on whether or not the proposed implementations should be accepted or not. In conclusion, I believe that standard setting boards should seriously consider proposals to eliminate the choice in accounting treatment for leases and force all companies to record leased items on the balance sheet as an asset as well as a liability.
Cite this Accounting for Leases 3
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