Leases and their use as a financing vehicle
A lease may be accounted for as either a sale/purchase accompanied by debt financing or a rental contract, depending on the leasing agreement regardless of the legal structure of the contract. Accounting professionals and managers make use of the latitude in standards of accounting to control earnings and maintain financial reporting that is aggressive (Bailey and Sawers, 2012). Nonetheless, professional judgment may be considered necessary so as to differentiate between leases; it may still be very easy to misrepresent the facts on an organization’s balance sheet.
When accounting for leases, no liability or asset is recorded by an operating lease on the financial statements, and the amount paid may be expensed as it is incurred. Conversely, a capital lease may be recorded as both a liability and an asset on the financial statements; normally, at the rental payments’ present value. With that in mind, individuals and organizations may be in a position to misuse the recording of Capital Leases and Operating Leases to their advantage. As a result, the Financial Accounting Standards Board (FASB) made up specific guidelines that may be applied to establish the standards for Capital Leases to foster financial reporting in organizations (FASB.org, n.d).
Capital leases and operating leases
A Capital Lease ought to be non-cancellable, and one or more of the subsequent conditions ought to be met. The first condition is that the arrangement specifies that asset transfers' ownership to the lessee. The second condition is that the arrangement consists of a bargain purchase choice. The third condition is that the lease term may be equal to seventy-five percent or more, of the anticipated asset's economic life. The final condition is that the minimum lease payments' present value may be equal to or greater than ninety percent of the leased asset's fair value (Spiceland, 2007).
On the other hand, a lease may be regarded as an Operating lease stipulated that the above criteria are never met. Nevertheless, organizations still utilize a great deal of intentional lease contracts' structuring so as to steer clear of capitalization. According to Frecka, we ought to question the reason behind firm managers/lessees wanting to avoid placing leased assets and associated liabilities on their balance sheets (Frecka, 2008). Frecka states that, placing the leased assets and associated liabilities on the balance sheet may lead to breach of loan covenants, have an impact on the amount of reimbursement received by managers; for instance, if compensation is associated to the earnings of an organization. The leases may also increase equity ratios' debt. They may lead to higher-reported revenue for developing firms and can also lower the rates of return. All of these factors relate to the aspiration to provide the visual appeal that the economic performance of an organization may be stronger than it actually is, and that there may be lower risk in the organization’s capital structure (Frecka, 2008). For that reason, the Financial Accounting Standards Board (FASB) attempted to transform the manner in which leases are accounted for (Kranacher, (2011).
The FASB tentatively decided to reconfirm its strategy to propose the "right-of-use" model, an approach that is principles-based in leases' accounting; however, its opinions could be affected later by various issues arising during continuous discussions. The discussion was a component of FASB's non-decision making evaluation of comments obtained on the discussion paper referred to as Leases: Preliminary Views. This paper was released jointly with the IASB (International Accounting Standards Board). For lessee accounting, this discussion paper recommended, to demand lessees to acknowledge on the statement "right-of-use asset” of financial position and a liability for a requirement to pay all leases' rentals. The "right-of-use" model may be favored amongst financial statements' users who think it would get rid of existing structuring possibilities; thus, lead to accounting for lease agreements depending on substance as opposed to the transaction's type (Lugo, 2009).
Accounting for leases within an organization’s financial reports
To start with, accounting for leases may be very intricate and can alter the means by which a lease can be accounted for. The complexity may be the reason to take into account the residual value in leased assets. A lease's residual value may be the amount that a firm should expect to after selling a fixed asset at the conclusion of its useful life (Investorwords.com, 2010). This assertion has the meaning that a leased asset may only be an approximation of its true value at the conclusion of the lease and may be open to interpretation of individuals that record the leased asset. Moreover; this could necessarily mean that the lessee's minimum lease payments exclude any non-guaranteed residual value by the lessee (Spiceland, 2011). On the flip side, the lessor includes any non-guaranteed residual value by the lessee that may be guaranteed by a third-party guarantor. Regardless of whether minimum lease payments are similar, their present values will vary stipulated that the lessee makes use of a discount rate that is different from the implicit rate by the lessor. This would take place if the implicit rate surpasses the incremental borrowing rate by the lessee, or the lessee is oblivious of the implicit rate.
The second thing is that an option of bargain purchase can be made accessible to the lessee by the lessor which may be a provision in the lease agreement that provides the lessee the choice of buying the leased asset at a “discount” price. Consequently, it may be defined as a price adequately lower than the anticipated asset's fair value when the choice becomes exercisable (Spiceland, 2007).
Thirdly, executory costs may be costs that are usually associated with ownership of a property such as taxes, maintenance, and insurance. These are obligations of ownership that are assumed in a capital lease, to be transferred to the lessee. These expenses are paid for by the lessee as incurred, when paid by the lessee. On the other hand, rental payments are usually inflated, when paid by the lessor. These executory costs, as well as, any lessor profits, are omitted in the determination of minimum lease payments and continue to be expensed by the lessee, despite the fact that, they are paid by the lessor (Kaur, 2004).
Fourthly, initial direct costs in an operating lease may be recorded as pre-paid expenses and amortized as operating costs over the period of the lease. This procedure may be due to the operating leases' nature in which rental income may be earned over the term of the lease. Initial direct costs are matched up, together with depreciation and other related costs, with the rent earnings that they assist to generate. Nevertheless, initial direct costs in a direct financing lease may be amortized over the term of the lease. This may be accomplished through offsetting unearned income by the initial direct costs; thus recognizing the initial direct costs at a similar rate as the interest income to which it may be related. This treatment may be necessitated by the lease's nature. The only income a direct financing lease yields for the lessor may be the interest income, which may be earned over the term of the lease. Consequently, initial direct costs may be matched over the lease term. In a sales-type lease, initial direct costs are required by GAAP (Generally Accepted Accounting Principles) to be expensed in the sale period which may be at the lease's inception. This treatment presumes that in a sales-type lease the main reason for incurring these costs may be to facilitate the leased asset's sale.
Last but not least, there may be sale-leaseback agreements which on the surface seem as if they may be two independent transactions. Nevertheless, the lessee/seller still maintains the utilization of the asset prior to the sale-leaseback arrangement. In actuality, the lessee/seller has revenue from the sale and a non-cancelable duty to pay off a debt. In fact, the lessee/seller basically has borrowed cash to be reimbursed with interest over the term of the lease; hence, “substance over type” demands that the gain on the asset's sale will not be instantly recognized, but delayed and regarded over the lease term. According to John Hepp, an associate at the national professional standards group, lease accounting generally has a great deal of complexity and accounting for modifications may be no different. Stipulated that one modifies a lease, some of the credits and debits never work out intuitively and one needs to be careful (Whitehouse, 2010).
This notion typically suggests interdependency among the price at which the property is sold and the terms of the lease. Therefore, the earnings process may not be complete at the selling time; however, it may be completed over the lease term. Viewing the leaseback and the sale as a single transaction may be consistent with the principle of revenue realization. Nevertheless, despite the fact that, firm managers/lessees stay within appropriate GAAP (Generally Accepted Accounting Principles) principals and guidelines, there may be plenty of different approaches to make their balance sheets appear better to their stockholders. Hepp states that, organizations renegotiating leases are currently smart to take into consideration, not only current rules, but also new standards on lease that may be percolating in both the U.S. and globally. In a couple of years, it may not be so easy to hold leases off the balance sheet (Whitehouse, 2010).
Residual value can increase the lessor’s profits through obtaining an extra lease payment for a residual value that is guaranteed (Boobyer, 2003). Nonetheless, ownership may be transferred to the lessee; thus the lessee gains through the property reflecting a decreased depreciable amount in a bargain purchase option. In addition, through utilizing the sale-leaseback agreement, the property will be refinanced by the lessee for an interest rate that is lower and still maintain use of the property; thus, the lessor may make cash that may assist on the financials. Hence, the choice to lease a property appears to be highly worthwhile for both the lessee and the lessor.
The primary advantage for the lessee may be low monthly payments and a low down payment. On the flip side, the primary advantage for the lessor may be the capacity to sell more goods and sell the utilized property to the lessee at the conclusion of the lease, or to re-sell the utilized property for the remaining residual value after the valuable life of the property. For that reason, leasing asset or equipment may be beneficial for organizations as opposed to buying.
A lease may be accounted for as either a sale/purchase accompanied by debt financing or a rental contract depending on the leasing agreement regardless of the legal structure of the contract. Since, professional judgment may be required to differentiate between leases; it may still be very easy to misrepresent the facts on an organization’s balance sheet. As a result, among the queries that the Financial Accounting Standards Board (FASB) board members brought up was whether the board would require to deal with issues on service as opposed to lease. Thomas Linsmeier, a FASB board member, pointed to a possible "slippery slope" where organizations would end up getting an appliance property that may be leased inclusive of some service agreement (Lugo, 2009).
Bailey, W., and Sawers, K. (2012). “In GAAP We Trust: Examining How Trust Influences
Nonprofessional Investor Decisions Under Rules-Based and Principles-Based Standards.” Behavioral Research in Accounting. 24(1), 25-46.
Boobyer, C. (2003). Leasing & Asset Finance. (4th Ed.). Euromoney Books.
FASB.org. (n.d). “Facts about FASB.” FASB.org. Retrieved on Feb 1, 2015, from;
Frecka, T. (2008). Ethical Issues in Financial Reporting: Is Intentional Structuring of Lease
Contracts to Avoid Capitalization Unethical? Journal of Business Ethics, 80(1), 45-59.
Investorwords.com. (2010). “Residual value,” www.investorwords.com. Retrieved on Feb 1,
Kaur, R. (2004). Lease Accounting: Theory and Practice. Deep & Deep Publications.
Kranacher, M. (2011). “FASB Looks to the Future: Standards Setting in the Post-
Convergence World.” The CPA Journal. 81(12), 17-24.
Larsen, E. (2006). Modern advanced accounting. (10th Ed.). Boston, MA.: McGraw-Hill Irwin.
Lugo, D. (2009). “FASB Views Comments on Lease Accounting, Will Address Lessor
Accounting With IASB,” Accounting Policy & Practice Report. Retrieved on Feb 1, 2015, from; http://www.pcfr.org/downloads/second_091809_bna_article_releases.pdf
Spiceland, J., Sepe, J. and Nelson, M. (2011). Intermediate Accounting. (6th Ed.). New York,
Spiceland, J., Sepe, J. and Tomassini, L. (2007). Intermediate accounting (4th Ed.). New
York, N.Y.: McGraw-Hill Irwin.
Whitehouse, T. (2010). Debt, Lease Restructurings Pose Fresh Challenges. Compliance
Week, 7(72), 24-71.