Current Issues in Accounting: Lease Accounting

Executive Summary

In respect of leasing transactions of the entities, presently both IASB and FASB provide for different accounting standards. IAS 17 Leases and its equivalent requirements in US GAAP provide for financial and operating leases. The categorization of the leases into these two classes is based on several considerations. The boards are of the opinion that the current accounting standards in respect of lease transactions of the entities do not meet the information needs of investors.

The main reason for such an opinion is because operating leases are not recorded on the balance sheet and the provision of current requirements has not resulted in the expected way to make the firms show the true nature of the individual transactions. In many cases, the firms have taken advantage of these provisions and have made the lease contracts in such a way to avoid them being caught in any of these four criteria. The existence of two entirely different accounting models for lease contracts enables the firms to account for the lease transactions differently. This makes the comparison of the financial statements more difficult for investors and they are unable to understand and compare the information.

Further, the existence of two accounting standards provides opportunities to structure transactions in the way the entities like as to achieve a specific lease classification and accounting treatment according to their wishes. Therefore, the boards have decided to incorporate fundamental changes in lease accounting and the proposed model is expected to deal with these issues. The exposure draft issued by the AASB explains the proposed changes and the impact of the adoption of such changes in the accounting for leases in the context of Australia. The exposure draft has also raised certain questions about the proposed changes and has invited answers and comments of the public on the proposed changes to lease accounting. This paper elaborates on the purpose and impact of these changes.

Introduction

“Leasing of equipment, real estate, and other assets has been and continues to be a significant source of financing for businesses in all industries,” (Rodger & McElwain, 2010). In order to recognize the income in respect of lease transactions, an appropriate method of accounting is necessary so that the lessor and lessee can disclose the treatment of leased assets properly in their books. The necessity for arriving at a proper accounting method stems from two considerations. First, if lease rentals are recognized as per the lease agreement, there is likely to be a distortion in the profit and loss account.

Secondly, if the lessee does not disclose the leased assets in his balance sheet there are chances of distortions of the financial status of the lessee. Recognizing this need for proper accounting of lease financing transactions the International Accounting Standards Board (IASB) has issued IAS 17 in respect of the leasing and financial instruments in the year 1982. It is observed that in spite of the changes that these standards propose to bring about the companies are still able to resort to Off-Balance Sheet Financing, which vitiates the objectives of the standards introduced by IASB. It is also necessary to compare the accounting and disclosure of leasing transactions prescribed by FASB Statement no.13 “Accounting for Leases”.

Statement of Financial Accounting Standards 13, which deals exclusively with the leasing transactions under US GAAP (SFAS 13), requires that there must necessarily be a distinction between both operating and capital leases. For making this distinction explicit, the standard has specified four specific criteria like transfer of ownership at the end of the lease, bargain price options, an extension of the lease for 75 percent of the asset’s life and present value of lease payments.

The purpose for specifying such criteria is to ensure that the lease transactions are characterized with their natural intentions, and are classified as capital or lease transactions depending upon the true nature of such transactions. “If a contract satisfies any of the four criteria, it must be recognized as a capital lease in the financial statements,” (Shortridge & Myring, 2004).

Thus, both the standards IAS 17 Leases and equivalent requirements in the US GAAP have the financial and operating lease categories and the standards have categorized the leases based on a number of different factors. When the lease is categorized as a finance lease, there is the requirement to show the value of assets and liabilities on the balance sheet of the lessee. However, when the entity classifies the lease as an operating lease, the lessee is under no obligation to show the effect of the lease transactions in their financial statements. The lease payments are accounted as expenses over the term of the lease. This presents a situation that the investors have to make an estimation of the effect of operating leases on the financial leverage and earnings of the entity.

On the other hand, if the lessee is made to record the assets and liabilities, which arise from all the leasing contracts it would provide better information for all the investors to understand the financial implications of all leasing activities undertaken by the entities concerned. It has been observed that there have been greater deficiencies in the quality of financial information as provided by the lessee than the lessors do. However, it is the belief of many that there should be a consistent accounting for both lessor and lessee as a common global standard proposed by the standard setters FASB and IASB (Financial Accounting Standards Board, 2010). The exposure draft proposes a common and consistent accounting model for both lessees and lessors.

Research Method

This research on the exposure draft has adopted an exploratory research based on secondary data and information collected from the available sources. Where there is no possibility of defining a problem precisely so that a research study can be undertaken, exploratory research can be adopted as the appropriate research method. The adoption of exploratory research enhances the possibility of selecting most suitable research design and data collection method.

Data and information collected through secondary research largely support the exploratory research. Exploratory research is one that does not rely on any previous model to base the current research. The researcher is forced to adopt exploratory research when he is not supported by any theories established prior to the current study. In some cases, the researcher may decide to use exploratory research, even if earlier theories are present. The following are some of the reasons for such a decision.

1. The researcher may have an intention to document the entire research as much as possible with no limitations that the topics should have any relevance to the prior researches.
2. The objectives of the current research might be completely different from the previous researches and the current research has the objective of exhibiting its extraordinary character, which the previous studies cannot attempt
3. There is a phenomenological approach attached to the current study with the objective of obtaining a deeper knowledge on the topic and a total distrust on the previous findings and theories.

Thus the exploratory study implies that there is very little known about the subject proposed to be studied at the start of the process of the study and the researcher undertakes to proceed with the study from the scratch with very little knowledge of the scope of the study. Under this method, the researcher does not have any opportunity of making proper plans in advance to conduct the study.

IAS 17Framework

For assessing the effectiveness of the proposed amendments to lease accounting, it is important to understand the nature of accounting for finance and operating leases by a lessee and disclosures in their financial statements under both standards. IAS 17 Leases provides the accounting treatment for a finance lease and operating lease by the lessee.

Accounting and Disclosure under IAS 17 by Lessee

“A finance lease should be reflected in the balance sheet of a lessee by recording an asset and a liability at amounts equal at the inception of the lease to the fair value of the leased asset net of grants and tax credits receivable by the lessor; if lower at the present value of the minimum lease payments.” (Khan, 2007) The lessee should be appropriated between the finance charge and the reduction of the outstanding liability. A finance lease involves the accounting of the depreciation charge for the leased asset as well as the financing charge for the relevant accounting period. In respect of the operating lease, the rental expenses for the accounting period shall be charged to income. The expense against income should be considered on a methodical basis, which represents the lease model of the benefits for the user.

The amount of the assets that are subject to finance lease should be disclosed at the values as at the balance sheet date. Liabilities relating to the leased asset should be disclosed separately from other liabilities. The liabilities are to be differentiated between the current and long-term portions. The lessee’s commitment for minimum lease payments under finance lease or non-cancellable operating lease having tenure of more than a year should be disclosed in summary form. This disclosure should specify the amounts and periods in which payments would become due. The accounting statements should also specifically disclose any significant financing restrictions or other conditions attached to the leases.

Accounting and Disclosure under IAS 17 by Lessor

An asset held by the lessor under finance lease should not be disclosed in the balance sheet as property, plant and equipment. Alternatively the asset item should be shown as receivable at value that equals the net investment in the lease. “The recognition of finance income should be based on a pattern reflecting a constant periodic rate of return on either the lessor’s net investment outstanding or the net cash investment outstanding in respect of the finance lease,” (New Zealand Society of Accountants, 1990).

The main purpose of the proposed changes in IAS 17 is to prescribe the companies the treatment of land and buildings. The change requires the companies to treat the land and building as separate leases. Now the business entities have to arrive at the rental values of land and buildings separately. Similarly, the type of lease has to be determined by them and should be accounted for.

Comparison of IAS 17 with FASB Statement No 13

It is also necessary to compare the accounting and disclosure of leasing transactions prescribed by FASB Statement no.13 “Accounting for Leases”. Statement of Financial Accounting Standards 13, which deals exclusively with the leasing transactions under US GAAP (SFAS 13), requires that there must necessarily be a distinction between both operating and capital lease. For making this distinction explicit, the standard has specified four specific criteria like transfer of ownership at the end of the lease, bargain price options, extension of lease for 75 percent of the asset’s life and present value of lease payments.

The purpose for specifying such criteria is to ensure that the lease transactions are characterized with their natural intentions and classified as capital or lease transaction depending upon the true nature of such transactions… If a contract satisfies any of the four criteria, it must be recognized as a capital lease in the financial statements.

While comparing IAS 17 and FASB Statement No 13 a number of similarities can be noticed. “. “Both standards define leases similarly, and both require that a leased item be recognized as an asset on the lessee’s balance sheet for leases under which substantially all the risks and rewards incident to ownership of the leased asset are transferred to the lessee (that is, for leases classified as capital leases (Statement 13) or finance leases (IAS 17)).” (US Securities and Exchange Commission, 2000)

The lessee need not recognize the asset if the asset is classified as an operating lease. However, the implementation guidance provided by IAS 17 for the determination of lease classification is less detailed as compared to the corresponding statement No. 13. For instance there are specific criteria prescribed by the FASB statement which need to be met for determining whether a leased asset item should be classified, whereas IAS 17 relies on the assessment and judgment of the management to determine the ‘substance’ of the lease transaction.

It is a complex process to predict how often the leased items that would be eligible to be capitalized under Statement 13 would be treated under IAS 17 for capitalization purposes. The “bright line” approach being followed by Statement 13 removes largely the subjective assessment by the management of the substance of the lease transaction to decide whether it is a capital lease or an operating lease. “However, it also permits lease transactions to be structured to meet (or to avoid meeting) the specified criteria,” (US Securities and Exchange Commission, 2000).

On the other hand, the approach by IAS 17 provides more room for subjective judgments in deciding the substance of the lease transaction. Therefore, in the absence of specific criteria it is difficult to determine whether all the entities apply the same criteria in determining the substance of the lease transactions for accounting and disclosure under IAS 17. Because of the element of judgment involved in the recognition of the lease transaction under IAS 17, the approach under IAS 17 may allow the classification in the balance sheet of a lease, which in reality is a capital lease. However, such capital lease may not meet the basic requirements of SFRS 13. This classification may be done irrespective of the fact whether the item is classified or unclassified.

This would obviously create problems in comparing the accounting information by the users since they may not represent the assets and liabilities in the same way. This problem will become more prominent in cases where the investors look at the financial statements of different entities for evaluating the financial soundness by making a ratio analysis and measuring the relative financial efficiency of the entities.

Effectiveness of IAS 17

“Both standards define leases similarly, and both require that a leased item be recognized as an asset on the lessee’s balance sheet for leases under which substantially all the risks and rewards incident to ownership of the leased asset are transferred to the lessee (that is, for leases classified as capital leases (Statement 13) or finance leases (IAS 17),” (US Securities and Exchange Commission, 2000).

Thus, IAS 17 has made it difficult for the companies to execute lease agreements with minimum requirements to be used to cover leasing as “off balance sheet financing”

However, the provision of such specification has not resulted in the expected way to make the firms show the true nature of the individual transactions. In many cases, the firms have taken advantage of these provisions and have made the lease contracts in such a way to avoid them being caught in any of these four criteria. “Because precise rules were established, companies carefully structured lease contracts to qualify as operating leases,” (Shortridge & Myring, 2004).

Recent Proposals on Modifications to IAS 17

In March 2009, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have published the discussion paper Leases: Preliminary View and the comment period for representing the viewpoints ended in July 2009. The issue of the discussion paper was considered necessary in the light of the criticisms leveled against IAS 17 and Statement No 13 as they are more reliant on subjective judgments and are rigid in defining the thresholds. It is believed that such excessive dependance on subjective judgments has led to the accounting of same type of leasing transactions by the entities in different ways. It also allowed the entities to structure the leases to arrive at any particular way of presenting the results in the financial statements prepared and presented by them.

The debates by the Boards considered the scope of lease accounting by the lessor and the lessee. Although initially the Boards agreed that both the lessor and lessee accounting needs to be considered, the Boards later on revised their stand to the effect that while there will be views expressed on the lessee accounting, the lessor accounting would be left to remain in status quo. Therefore, there have been no preliminary views expressed on the lessor accounting and disclosure of lease transactions.

First, the Boards expressed the view that the scope of the proposed model should be based within the context of the current lease recording procedures, mainly because the entities have become familiar with these standards. In respect of the lessee accounting of the lease transactions the boards expressed the views that on the overall model

“Recognize a single right-of-use asset and a single liability for the obligation to pay rentals.” (ISA Plus, 2009)

In the matter of measuring the right-of-use asset, the preliminary view of IAS states

“Initially measure at cost, which would equal “the present value of the lease payments discounted using the lessee’s incremental borrowing rate. Subsequently measure the asset on an amortised cost basis over

1. the shorter of the lease term or the economic life or
2. if the lessee is expected to obtain title, the economic life.” (ISA Plus, 2009)

In respect of measuring the obligation to pay rentals, the Board is of the view that the initial measurement should follow the

“The present value of the lease payments discounted using the lessee’s incremental borrowing rate. Subsequently measure by using an amortised cost based approach in which interest is accrued on the outstanding obligation to pay rentals.” (ISA Plus, 2009)

The Board has expressed similar preliminary views on measurement or reassessment of the incremental borrowing rate, measurement of the changes in estimated cash flows, determination of lease term and reassessment of lease term, which have been made to rely mostly on the subjective assessment of the management.

The scope as expressed in the preliminary views provide for the exclusion for either leases of non-core assets or short-term leases. However all leases will give rise to some form of assets and liabilities. Therefore, such exclusion does not provide for any conceptual justification to exclude these classes of leases from the scope of the proposed new standards. Such exclusions may also provide for complexities in treatment for accounting, disclosure and comparability and will enhance the opportunities for entities structuring the lease transactions (ISAB, 2009).

The approach taken by the proposed model reflects the economic substance of a lease transaction and therefore the disclosure may be able to provide more relevant information than the information that are being currently provided to the users. It is important that the proposed model retains the distinction between capital and operating leases as such, classification represents the genuine economic differences between different types of leases (ISAB, 2009).

The recognition of a single right of use to an asset or liability may take away the clarity in disclosure and is likely to result in complexities in comparison. However, there is an opposite view to this in that the existing different components approach is too complex and expensive to collect and provide the necessary information. The proposed single asset and single liability concept will reflect the inter-relatedness of the lease components such as options, contingent rentals and the non-callable contractual period, which are more meaningful in analyzing the nature and scope of lease transactions.

The board’s tentative decision to measure the obligation of the lessee on rental payments using the present value of the lease payments adds credibility to the transaction. However, the discounting rate to be used to arrive at the current value is debatable as there is the option of using the lessees’ increasing interest rate or the interest rate implicitly attached to the lease transaction.

Similarly the view of the board to measure the lessee’s right of use asset at cost appears to have validity and relevance as it is consistent with the measurement of other non-financial assets. The view of the board to adopt an amortized cost-based approach instead of a linked approach to measure the obligation to pay rentals subsequently and the right to use asset can be considered as relevant and practical as such an approach is consistent with the current guide lines for non-derivative financial liabilities and non-financial assets and the approach is likely to increase comparability among reporting entities.

However, the linked approach has its own advantage in that the linked approach reflects the economics of most of the lease contracts as the costs are evenly distributed over the lease term. In addition, in the linked approach the link between the right to use asset and the obligation to pay rentals are linked throughout the term of the lease.

The views expressed by the board on the option to adopt fair value for measuring the obligations to pay rentals, reassessment of interest rates to revise the obligation to pay rentals by the lessee to reflect changes in the incremental borrowing rates, providing guidance for accounting the obligations to pay rentals, and the option to describe decreases in the right of use asset to be treated as amortization or depreciation rather than as rental expense are considered adding to the subjective elements to the scope of the revision in the standard.

Proposals by the Recent Exposure Draft

The proposed requirements are expected to affect any entity, which enters into a lease transaction. The proposals also provide for some exemptions. When implemented the proposed changes would take over from the current standards under IFRS and GAAP.

The main proposals under the draft exposure include the requirement that the entities should make use of a right-of-use model while recording for the lease transactions. For leases to be accounted under the IFRS this condition would imply that

• a lessee would recognise an asset representing its right to use the leased (‘underlying’) asset for the lease term (the ‘right-of-use’ asset) and a liability to make lease payments.
• a lessor would recognise an asset representing its right to receive lease payments and, depending on its exposure to risks or benefits associated with the underlying asset, would either:
  • recognise a lease liability while continuing to recognise the underlying asset (a performance obligation approach); or
  • derecognise the rights in the underlying asset that it transfers to the lessee and continue to recognise a residual asset representing its rights to the underlying asset at the end of the lease term (a derecognition approach)” (AASB Exposure Draft, 2010).

The proposals contained in the exposure draft would result in both the lessors and lessees making significant changes to their accounting practices in respect of their lease transactions. In addition, the exposure draft proposes to allow the lessors and lessees to use a simplified method of accounting for short-term leases (IFRS, 2010).

Changes in the Accounting by Lessees

The foremost change in lease accounting is that all leases would appear on the balance sheet irrespective of the fact that whether the lease is operating or financial one (Ernst & Young, 2010). In the right-of-use accounting model, the lessors and lessees account for the present value of the lease payments and the value of the assets and liabilities are subsequently measured using a cost-based method. “The model would require lessees to recognize an asset representing the right to use the underlying property over the estimated lease term (the right-of-use asset) and a liability to make estimated future lease payments in their statements of financial position for each lease,” (KPMG, 2010). The proposals assume that in a lease transaction, “a lessee has acquired a right to use the underlying asset, and it pays for that right with the lease payments,” (Lavi, 2010).

“Lessees will recognize a right-of-use asset and a liability for their obligation to make lease payments for all leases. “Off-balance-sheet” leases and the concept of “lease classification” in the current accounting model will no longer exist for lessees,” (Deloitte, 2010).

While accounting for the lease transaction, “a lessee would record: an asset for its right to use the underlying asset (the right-of-use asset), and a liability to pay rentals (liability for lease payments). The right-of-use asset would originally be recorded at the present value of the lease payments. It would then be amortised over the life of the lease and tested for impairment” (Lavi, 2010). Under IFRS, the lessee is entitled to revalue the right-of-use asset value. “The right-of-use asset would be presented within the property, plant and equipment category on the balance-sheet, but separately from assets that the lessee owns” (Lavi, 2010). However, the leased asset would be shown separately from the assets owned by the lessee.

The leases are currently classified into finance and operating leases by both IFRS and GAAP.

“Lessees would be most affected if they have a significant portfolio of assets held under operating leases, especially those with leases of property. At present, US GAAP and IFRSs account for the lease payments arising from operating leases by recognizing them in the period in which they occur. The proposals would require lessees to recognize the assets and liabilities arising from those leases,” (Financial Accounting Standards Board, 2010).

Since the proposed changes provide for the accounting of options and contingent rentals they are expected to bring significant changes in measuring the assets and liabilities arising from the lease transactions. Therefore, even though the proposed changes may be fundamental for the leases, which are currently categorized as finance, leases they are likely to bring substantial changes. “In addition, the pattern of income and expense recognition in the income statement would change significantly” (Financial Accounting Standards Board, 2010).

Changes in the Accounting by Lessors

The exposure draft would provide for a method in which “the accounting would reflect the exposure of the lessor to the risks or benefits of the underlying asset. When the lease transfers significant risks or benefits of the underlying asset to the lessee, the lessor would apply the de-recognition approach. When the lessor retains exposure to significant risks or benefits of the underlying asset the lessor would apply the performance obligation approach” (Lavi, 2010).

Under derecognition approach the lessor will be obligated to take part of the underlying asset off its balance sheet. In the place of the derecognized value, the lessor would recognize the right to receive the lease payments. Consequently, it is possible for the lessor to record a gain on the start of the lease when the lessor uses the derecognition approach.

The alternative method of performance obligation prescribes that the entity providing the lease is allowed to keep the value of the asset covered by the lease transaction in its balance sheet. In addition, the lessor would record a right to receive lease payments. Simultaneously the entity offering the lease would also record the liability to allow the entity using the leased asset to use the property covered by the lease. This liability would represent the lease liability. The lessor would record the income from the lease continuously over the expected life of the lease period. “If a lessor retains exposure to significant risks or benefits associated with the underlying asset, the lessor would continue to recognise the underlying asset and in addition recognise a right to receive lease payments and a lease liability,” (Exposure Draft, 2010).

The proposed changes in the lessor accounting would also undergo substantial changes from the existing provisions of IFRS and US GAAP. The lessor will be mandated to either apply a performance obligation approach or de-recognition approach. The particular approach the lessor applies would depend on the extent to which the lessor retains exposure to the risks and benefits, which are associated with the asset connected with the lease. “A “performance obligation approach” would be used if the organization retains exposure to significant risks of the underlying asset. Under this approach, the lessor would continue to recognize the underlying asset and, in addition, recognize an asset for the right to receive lease payments and a liability for the obligation to give another organization the right to use the asset” (Horneff, 2010).

The lessor would be construed to have satisfied the liabilities on the lease transaction continuously over the lease period. Because of this reason, the lessor is obligated to recognize the lease income continuously over the lease period.

“If a lessor does not retain exposure to significant risks or benefits associated with an underlying asset, the lessor shall apply the derecognition approach to the lease. That pattern of income recognition is similar to the pattern of revenue recognition currently required for manufacturer/dealer lessors” (Financial Accounting Standards Board, 2010).

However, the draft exposure provides for substantial changes in the measurement of the right to receiver lease payments. “However, there would be significant changes in the measurement of the right to receive lease payments, the recognition of lease income and the recognition and measurement of residual assets” (Financial Accounting Standards Board, 2010). In respect of such leases, the lessor would meet the lease liability as at the start of the lease by handing over the right-of-use asset to the lessee. Consequently, the lessor would recognize lease income, which represents the sale value of right-of-use of the underlying asset.

Lease Term and Contingent Features

It is usual that the leasing transactions include variable features. For instance, lease contracts provide the options for extending or terminating the lease or for contingent rentals. Under contingent rentals, lease contract the lease rent may vary depending upon the sales. There may be lease agreements based on residual value guarantees.

“The proposals would require lessees and lessors to determine the assets and liabilities on the basis of the longest possible lease term that is more likely than not to occur. Lessees would always include contingent rentals but lessors would only include contingent rentals that they can measure reliably. Lessees and lessors must also include estimates of residual value guarantees. Including these items informs investors about expected cash flows. Current requirements generally exclude such items, making it more difficult for investors to estimate future cash flows” (Lavi, 2010).

It is the belief of the Boards being the standard setters that inclusion of contingent rentals and residual value guarantees would enable the investors to have more information about the future cash flows that are likely to arise from the lease contracts. The non-inclusion of optional periods may lead to the understating of the related right-of-use asset and right to receive lease payments. It may also create structuring opportunities.

Other Issues and Responses of the Boards

The Boards are of the opinion that the leases of non-core assets can lead to the accumulation of significant assets and liabilities in the hands of the lessors and lessees and therefore considered the information on these assets and liabilities is more relevant to the investors to enable them take meaningful investment decisions. The exposure draft proposes to distinguish between service and lease contracts by using the existing guidance, which incorporates the principles under IFRIC 4 Determining whether an Arrangement contains a Lease into the exposure draft.

The exposure does not provide for the accounting of the lessor’s right to receive lease payments as a financial asset. The draft does not also provide for accounting of the lessee’s liability to make lease payments as a financial liability. “Although the right to receive lease payments meet the definition of a financial asset, the boards think that such a right often has features unique to leases such as options and contingent rentals,” (Financial Accounting Standards Board, 2010). Therefore, the exposure draft has proposed specific accounting treatments in respect of such assets and liabilities. It is to be noted that the proposals do not cover all lease transactions. The proposals do not cover

• “Contracts that are labelled as leases but are actually purchase or sale arrangements are not covered by the proposals.
• The accounting for some specialised assets will remain unaffected. Lessors with investment properties accounted for at fair value under IAS 40 Investment Property will continue to apply the requirements in IAS 40. The accounting for biological assets will remain within IAS 41 Agriculture. The requirements in those standards already provide sufficient useful information.
• Leases of intangible assets (for example: software, patents and licences) and leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources are excluded until the accounting for such items can be considered more broadly” (IASB, 2010)

There are different questions included in the exposure draft, which invites comments from the respondents on the proposed changes to the accounting standards. The respondents are requested to comment on any or all of the questions. They may also comment on any other matters, which they think that the IASB should consider while finalizing the proposals. The comments sent will be considered by both the boards since this is a joint project of both IASB and FASB. The Boards will consider all the comments and feedbacks received on the proposals made by the exposure draft. The boards have also proposed to conduct public round-table meetings towards the end of the comment period and issue new standards in the year 2011.

Conclusion

The main purpose of the proposed changes in IAS 17 is to prescribe the companies the treatment of land and buildings. The change requires the companies to treat the land and building as separate leases. Now the business entities have to arrive at the rental values of land and buildings separately. Similarly, the type of lease has to be determined by them and should be accounted for. Thus, IAS 17 has made it difficult for the companies to execute lease agreements with minimum requirements to be used to cover leasing as an off balance sheet financing item.

However, Statements on Financial Accounting Standards 13, which deals exclusively with the leasing transactions under US GAAP (SFAS 13) requires there must necessarily be a distinction between both operating and capital lease. For making this distinction explicit, the standard has specified four specific criteria like transfer of ownership at the end of the lease, bargain price options, extension of lease for seventy-five percent of the asset’s life and present value of lease payments.

The purpose for specifying such criteria is to ensure that the lease transactions are characterized with their natural intentions, and classified as capital or lease transaction, depending upon the true nature of such transactions. The proposed changes by both the boards to the existing accounting treatments for leases are an attempt to rationalize the practices and to include other aspects of leasing like contingent rentals and residual value guarantees. The proposed changes will also eliminate the specific criteria provided for by SFAS 13 and the subsequent standard 840 under the GAAP. The proposed changes are expected to provide for additional information to the investors on the expected future cash flows from the leasing transactions undertaken by the entities.

However, it remains to be seen whether the proposed changes to the accounting treatments would result in the expected way to make the firms show the true nature of the individual transactions. Considering the changes in the disclosure of contingent values and the approaches in accounting (derecognition and performance obligation approaches) the proposed changes are likely to provide additional information to the investors than what is currently available to them. To this extent, the proposed changes may be considered worth the while.

References

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