INTROUDCTION AASB 117 Leases requires lessees to classify leases as either finance leases or operating leases. The accounting treatment required under each approach is very different and this has raised concerns by investors and other financial statement users regarding the usefulness of the information provided. This essay will critically discuss and the criticisms and usefulness of lease accounting treatment. It will also examine lessee firm’s responses to Australian Standard 117 Accounting for Leases.
Definition of capital and operating lease AASB 117 provides the current rules for leases. In general terms, the lessee classifies leasing transactions under one of two categories. The current state of practice requires the capitalisation of certain lease contract that meet specific criteria related to the transfer of substantially all the benefits and risks of ownership from the lessor to the lessee. If sufficient risks and rewards of ownership are transferred to the lessee, the lessee records the transaction as a purchase (i. e. a capital lease); absent the transfer of sufficient risks and rewards of ownership, the lessee records the transaction as a rental (i. e. , an operating lease). Issues The existing accounting model for leases has been criticized for failing to meet the needs of users of financial statements. IASB and FASB noted a number of criticisms of the existing accounting requirements, including the following The existence of two very different accounting models for leases means that similar transactions can be accounted for very differently.
This reduces comparability for users. Preparers and auditors have criticised the existing model for its complexity. In particular, it has proved difficult to define the dividing line between finance leases and operating leases in a principled way. Consequently, the standards use a mixture of subjective judgments and ‘bright-line’ tests that can be difficult apply The dominant issue is there are significant and growing differences between the accounting model for leases and other contractual arrangements.
Whether lease should be classified as finance/capital leases or operating leases, has essential influences on other issues such as capitalisation of finance/capital leases and disclosure of operating leases by lessees. Without a clear distinction between a finance/ capital lease and an operating lease, it is unlikely that the lessee be required to capitalise the lease. This has led to inconsistent accounting for arrangements that meet the definition of a lease and similar arrangement that do not.
According to AASB 117, the operating lease structure is a form of off-balance sheet accounting, which means the lease obligation is not reported as a liability on the balance sheet. Critics claims that as a result of desirability of operating lease classification, lease parties commonly structure leases in such a way to avoid capital lease accounting by a thin margin and uses it as a source of off-balance-sheet financing This is a source of unrecognised financing and it can be difficult for users to understand. Moreover, the adjustments are inconsistent and frequently understate the lease obligations.
Furthermore, the lack of transparency caused by current lease classification rules and the resulting lease structuring that occurs to avoid meeting those rules creates significant problems for users in assessing the true financial condition and risk of companies. It can even affects naively calculated debt-equity ratios, the “ footnote only” disclosure and further lead to financial analysts making ‘faulty decisions’. Hence, the information available to users in the notes to the financial statement is insufficient for them to make reliable adjustments to the recognised amounts.
Nevertheless, certainly, not all companies intentionally structure lease arrangements as operating leases for the sole purpose of avoiding balance-sheet capitalization and the resulting negative impacts on financial ratios. Indeed, operating leasing arrangements have many economic advantages, perhaps most notably in providing companies with access to capital that might not be available through other means CONCLUSION Following the presentation of different views and the arguments, it is concluded that the theoretical backgrounds underlying lease accounting issues are far from harmonious and the debate is expected to remain.
These results suggest that the FASB should reexamine the current rules-based approach to leases and adopt a more principles-based approach requiring lessees to capitalize their economic interests in all significant noncancelable leases. Such an approach would result in an accounting treatment reflecting the economic substance of the transaction, rather than driving the structure of the transaction. Users could make more meaningful comparative evaluations of companies that engage in different types of leasing contracts and better assess the risk of companies that currently structure leases specifically to avoid lease capitalization.