Accounting Elimination of Operating Leases (Essay Sample)

Accounting Elimination of Operating Leases
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Abstract
Leases have been used over a thousand of years. A lease can be defined as a contractual arrangement obligating the lessee to pay the lesser rent for use of the asset. Rental agreement is used to denote leases in which the property is tangible. In early years leases were used as a security of money lended.itf the borrower failed to pay the lease would be transformed into a fee for the lender. However form 15th century farmers begun using leases to acquire and farm in a land rather than buying it. Today most companies lease certain assets and pay periodic payments for their use. Tenancy principles also apply to real property and personal property.
Accounting Elimination of Operating Leases
In 2012, The International Accounting Standards (IASB) Board and Financial Accounting Standards Board (FASB) proposed a change to the widely accepted accounting principles (GAAP) which would eliminate the concept of "operating leases" and, treat all leases as "capital leases." Implementation of this change will directly impact contractors’ future decisions on whether to buy or lease facilities and equipment. This proposal may mark the end of the interest component in all capital leases. Contractors should study this proposed changes in GAAP and analyze its effects and decide whether to lease or buy moveable assets.
This change would bring with the biggest impact ever on lessees currently considering an operating lease or already using a leased equipment. The current rules states that, if a value of sums due to the lease agreement is 90% or less than the original value of an asset, the lease should automatically record as an operating lease. Further, if the present value exceeds 90%, the lease shall be treated a capital lease due to the fact that it transfers all substantial benefits and risks ancillary to the lease.
Distinction between capital leases and operating and is that capital leases are treated as purchased assets, which are appreciated and depreciated over time while operating leases are treated as generating annual costs. Under the GAAP as it is present, a lease of a capital nature obligates the lessee to treat lease incomes as s form of financing, where the proportion of lease payments represents interest.
Leasing is a widely used source of financing. It enables business entities, from private to corporations, to use property, plants and, machinery without making large initial cash investment. Many Companies currently account for leases as either operating leases or finance leases. Lease classification is based on complex accounting rules; if a lease is treated as an operating lease, both the leased asset and the obligation to pay are not recorded on the trial balance sheet. Instead, rent payments are recorded throughout the lease term.
A recent survey, conducted by accounting giant Grant Thornton on 2,800 companies across the world, revealed that 54% of businesses were not aware of, and consequently unprepared for the dramatic change in global accounting standards in the past decade: the elimination of off-balance sheet leases.
The proposed changes in accounting principles would be effective at a date, not before 2015. The potential impact of these accounting principle modifications will manifest themselves in numerous ways, which include but not limited to;(i) Loan covenants: tenant balance sheets will look more a mere multiplication of losses and gains which may result in a tenant not being able to comply with loan agreements.(ii) Lease terms: lease terms will be shortened and without renewal options to avoid incurring more debt on tenant balance sheets; and (iii) Owning/leasing property: the distinction between leasing and owning property will diminish, forcing leading companies to look for more favorable way of owning property rather than leasing. (iv) Balance sheets: tenants will have to treat assets and liabilities as leases where in the past accounting rules, as an operating lease, they did not.
From the proposed changes, it is clear there is a direct advantage in that it would eliminate the "bright line" test. Rather, the proposed rules would take several factors into consideration before calculating the value that would go directly to the balance sheet. In addition, leases that which have formerly been classified as operating leases would no longer record be treated as a straight lease expense.
By not recording the rental obligation and leased asset on balance sheets, businesses can report stronger balance sheets and better return ratios. However, since the proposed accounting principles provides for disclosure of operating lease commitments in the lessee's audited financial accounts, creditors and investors will be the adjust the balance sheets and ratios for ratings and crediting purposes.
The International Accounting Standards (IASB) Board and Financial Accounting Standards Board (FASB) proposal comes with a number of challenges. First a recent survey, conducted by accounting giant Grant Thornton of 2,800 businesses across the globe, revealed that 54% of businesses were not aware of, and consequently unprepared for the dramatic change in global accounting standards in the past decade: the elimination of off-balance sheet leases. This could force many companies to incur extra expenses in shifting to the new rules.
The proposed elimination of operating leases accounting could greatly change the accounting principles of the lease or buy option process. Such decisions would purely depend on economic merit, rather than by the expected accounting result and estimations.
In addition, while cash flow under current and proposed standards does not change, agreements which contain covenants or performance bonuses and existing monitoring strategies will be affected. The changes also will create new temporary unique tax differences, since assets and liabilities recorded in the financial statements will not be recognized for tax purposes.
The proposed standard also will require in addition to the revised financial statement presentation, an additional disclosures in the footnotes to the financial statements. These disclosures will be based on judgments and assumptions identified in the initial measurement and recording of assets and liabilities. When facts or circumstances significantly change during the lease term, they will be a greater need for them to be disclosed.
By reducing the duration and depth of lease covenants or foregoing leases altogether these lesser strategies are bound to have the effect of increasing operational risk for lessors, which, in turn, could push lease prices up so as to cover up the costs of the risks. The Equipment Leasing & Finance Foundation commissioned IHS Global Insight to examine the potential economic impact of the proposed changes to lease accounting. They conducted a qualitative review on the provisions on the proposed changes, primarily focusing on experts’ opinions published by the reputed accounting firms. The results were compared and contrasted with the views of a representative sample of the comment letters.
The analysis found that operating leases been capitalized at $2 trillion of capitalized assets and a considerably correspondingly huge debt liability which would have been added to the balance sheets of United States business entities. For the average US economy, the front loading of those lease costs would continue until 2015 to reverse direction or stabilize. For industries and companies that are heavily depend on long-term leases to operate, the reversal or stabilization timeframe may be a bit longer. The analysis concluded that new accounting principles would have both negative and long term impact which the equity companies would report on their balance sheet.
The impact on the new accounting proposal would do a great harm for manufacturers and distributors because lease expense is often their largest operating cost other than materials and wages. By making it mandatory for manufacturers and distributors to recognize future liabilities for operating lease payments in their financial statements, these proposals will have a major impact on a business’s balance sheet, and some key ratios, and perhaps even impair its ability to attract financing. It will further present the business financial strength as weak unsecure that may cause its downfall due to lack of investors or financing.
It all goes back to leverage. The requirement to record lease liabilities and thus, long-term payment obligations on the balance sheet will result in substantially more leverage being added to the balance sheet. The impact would be the company’s inability to meet loan covenants and agreements it has with its bank, including debt service coverage and financial leverage ratios, and could also affect a bank’s calculation of tangible net worth.
Schools, universities and hospital, are likely to be affected as a result of the accounting standards change; these institutions are likely to see a significant drop in energy efficiency investment, as projects that are always funded through the operating budget would instead have to compete with all other capital projects. Fortunately, some universities and hospitals continue to see ancillary benefits in energy efficiency projects, beyond simply economic metrics (enhanced brand, educational opportunities) and have lower financial hurdle rates for projects, making the discounted cash flows on institutions projects much more attractive to them than to the private sector. In such institutions, investment will continue, undisrupted, in the face of the proposed accounting change.
The increase of debts in the accounting books will likely negatively impact a business ability to honor its bank debt obligations. These obligations can include a leverage...