This week an article was
published by Reuters Business on new accounting rules considered to be
implemented by the International Accounting Standards Board (IASB). The link which appeared is on http://www.reuters.com/article/us-accounts-regulations-leases-idUSKCN0UR00B20160113
The new rule considered
to be implemented on leasing should, according to Reuters, “shine clearer light
on debt”. According to the ruling, it would require leases of more than one
year to be published on balance sheets starting January 2019, and will affect
mostly companies such as airlines, shipping and retail. According to Reuters, listed
companies using IASB and US accounting rules have leases worth $3.3 trillion,
of which, 85% are off balance sheets.
So let us examine what is
leasing. When a company wants to use an asset, like a machinery, it can get the
asset in two ways: the first is to buy the asset, and the second, is to enter
into a lease agreement and lease it. A lease is a contract in which the lessor
(owner of asset) gives the lessee (the renter) the right to use an asset
for a specific period of time in exchange for periodic lease payments.
Leases can be of two
types: Operating lease and Capital lease. An operating lease is when the
lessor, the owner of the asset, gives the lessee the right to use the asset for
a limited period of time, but retains the risks and rewards of ownership. One
benefit of ownership of an asset is that the company can depreciate the asset
for tax purposes. Another benefit is that the owner of the asset can benefit
from the appreciation in the value of the asset. On the opposite side, the
company can lose if the asset become obsolete, and will lose from the depreciation
of the asset. If the company has to borrow to buy the asset, it will increase
the cost. The ratio of debt / equity will increase as well as the interest
coverage ratio.
The interest coverage
ratio essentially measures how many times over a company can pay its interest
payments with its available earnings. To the lessee, the benefits of leasing
are, not having to pay for the asset, does not have to borrow to buy the asset,
and also, the lessee may not want to use the asset for its full useful life. In
accounting for an operating lease, the lessor views the monthly lease payments
received as rental revenue, and the lessee regards these payments as rental
expense. No asset of liability relating to the lease (other than accrued rent
payable) relating to the lease, appears in the lessee’s balance sheet. So
operating leases are called off balance sheet financing.
A capital lease is
intended to provide financing to the lessee with use of the asset over most of
its useful life. In contrast to the operating lease, a capital lease transfers
ownership of the asset from the lessor to the lessee. So if a company leases a
car for a period of three years, at the end of the lease, title to the car will
be transferred at no additional cost to the lessee. Thus for a capital lease,
ownership is transferred at the end of the lease, an option to purchase the
asset exists at the end of the lease period for less than the market value, the
present value of the contractual future lease payments is at least 90% of the
current market value of the asset, and the lease period covers more than 75% of
the asset’s life.
So the company, say that leased the car, is
not just renting the use of the car, it is using the lease agreement as a means
of financing the purchase of the car. Capital lease is regarded from an
accounting point of view, as equivalent to a sale by the lessor to the lessee,
despite the fact that title has not yet being transferred.
The lessor then will
record the capital lease as a sale, and the lessee as a purchase. Interest
charges are also included in order to determine the amount of lease payments.
Commonly leased assets
are airplanes, buildings, and equipment and as for their duration one has short
term leases, and long term leases. Accounting rules require that certain long
term leases be treated as if the company bought the asset with debt financing.
In capital leases, a lease asset and a lease liability are recorded on the
balance sheet, while on the income statement, are recorded depreciation expense
and interest expense. As for the operating leases, no asset or liability are
recorded on the balance sheet, and as we explained above, the activity is off –
balance sheet. The only item recorded is rent expense on the income statement.
Therefore, accounting for
leases was controversial because operating lease accounting allows firms to
keep substantial financial obligations off their balance sheet, potentially
distorting the firm’s leverage. Now IASB considered the proposals to eliminate
operating lease accounting, and the time has come to reflect the true picture
of a company’s debt.
Bill T. Alexandratos
