As
the IASB-FASB joint international working group began its study of lease
accounting in late 2006 and early 2007, it had a number of staff documents
prepared to help observers at their meetings follow the working group’s discussions.
These documents are available on the IASB website (www.iasb.org) by following
the “Projects” link for “Leases.” They cover a wealth of information, including
the results of prior academic research on lease accounting and its potential implications
for the lease accounting project. Obtain the Information for Observers document
for the February 15, 2007 and March 22, 2007 meetings of the IASB-FASB joint
committee that deals with academic research on lease accounting. Alternatively,
research and read up on the academic accounting literature on lease accounting.
Instructions
(a)
Summarize the issues that have been addressed by academic research on lease
accounting.
(b)
In general, what were the findings of this research on each issue?
(c)
Identify what the implications are of the research findings for the development
of new accounting standards for leases.
(a) The issues that have been addressed by academic research on lease
accounting are as follows:
· To what extent would recognition of off-balance sheet leases affect financial
statements, and which industries would be most affected?
· What is the relationship between leases and other forms of financing,
including debt and equity? How do leases, in conjunction with debt, affect
equity risk?
· How is lease accounting information perceived or used by investors,
creditors, and other financial statement users?
· What was the impact of Statement of Financial Accounting Standards 13 on
market assessments of risk and profitability and on the use of leases relative
to other types of financing?
(b) The findings of the research on each issue are presented below.
·
The
impact of capitalizing leases
i.
Balance sheet measures such as
gearing or leverage ratios would be significantly increased by capitalization
of operating leases.
ii.
Performance measures such as
profit margin, return on assets, and asset turnover would also be affected by
capitalization of operating leases, although not as dramatically as balance
sheet measures.
iii.
The impact on balance sheet
and performance measures would be most pronounced for service industry firms
such as airlines, hotels, retailers, media agencies, and vehicle distributors.
iv.
Capitalization of operating
leases would likely alter the relative standing of firms within and across
industries for gearing and other debt-related ratios. In contrast,
capitalization of operating leases is not as likely to alter the relative
standing of firms for performance measures, within or across industries.
·
The
similarity between operating leases and debt
i. Disclosed capital leases under ASR 147 are positively associated with
equity risk, after controlling for debt levels (which also are associated with
equity risk).
ii. The present value of operating leases (calculated using a typical present
value approach or a factor approach) also is positively associated with equity
risk, after controlling for debt levels.
iii. Amounts paid under contingent fee lease arrangements are not associated
with equity risk, suggesting that the contingent fee component of lease
payments does not behave like debt in its effect on equity risk.
iv. Leases (operating leases in particular) appear to be partial substitutes
for debt financing, with leases partially consuming debt capacity.
· How lease accounting information is used
i.
Lending officers are willing
to lend at lower rates and assign higher credit ratings to firms that use more
operating leases than capital leases, suggesting either that lenders perceive
capital leases and operating leases to be economically different, or that
lenders are misled by the accounting.
ii.
At least one credit rating
firm consistently adjusts its debt and leverage analyses to recognize the
present value of operating leases, suggesting that it considers operating
leases to be equivalent to debt.
iii.
Stockbroker analysts do not
appear to capitalize operating leases when performing stock valuation or
forecasting.
iv.
Users and preparers often hold
quite distinct views on how to account for leases. However, they both seem to
agree on some important issues as well.
·
The
impact of SFAS 13
i.
The market’s assessment of
firms’ equity risk did not change following the adoption of SFAS 13. This
result holds for numerous measurements of equity risk across multiple
industries.
ii.
In
a side-by-side comparison of identical firms that differ only in their use of
capital or operating leases, CFOs, bank lenders, auditors, bond analysts, and
stock analysts tend to prefer the operating-lease firm over the capital-lease
firm on metrics such as profitability, ability to repay, and ability to predict
cash flows. This result seems at odds with the finding that SFAS 13 had no
impact on firms’ equity risk, but this difference may have occurred because
participants in these studies were assessing more than just equity risk when
expressing a preference for the operating-lease firm over the capital-lease
firm.
iii.
Firms mitigated the impact of
SFAS 13 by renegotiating the terms of lease contracts to avoid capital lease
criteria. Firms also shifted their financing away from fixed-price financing
toward equity financing. This result was documented in the United States and in
Australia in response to the issuance of their respective lease accounting
standards.
iv.
Stock prices declined for
firms that would have experienced tightened debt covenant restrictions as a
result of SFAS 13. The magnitude of the stock price decline was positively
associated with the change in the tightness in debt covenant restrictions that
would have resulted.
v.
No other stock price reactions
to events leading up to the issuance of SFAS 13 have been documented,
suggesting the possibility that the market’s reaction to any new lease
accounting standard also would be minimal.
(c) Identify what the implications are of the research findings for the
development of new accounting standards for leases.
Based on these studies and
other opinions, the IASB considered various accounting models for lease
accounting. It discussed
·
the
right-of-use (contract based) approach. In this approach, the lessee recognizes
its right to use the leased item and an obligation to pay for that item. The
lessor recognizes, as an asset, its right to receive payments from the lessee
and its residual interest in the leased item at the end of the lease.
·
the whole asset model. In this
approach, the lessee records the whole of the physical item on its balance
sheet. To correspond to that asset, the lessee recognizes two liabilities: the
obligation to make payments to the lessor and an obligation to return the
physical item at the end of the lease. The lessor recognizes its right to
receive payments from the lessee and its right to have the leased item returned
at the end of the lease.
·
the executory contract model.
In this approach, the lessee recognizes no assets or liabilities upon entering
into the lease contract. Lease rentals are recognised in profit or loss as they
become due. The lessor recognizes the leased item as an asset.
·
the model used in current
standards. The lessee either accounts for the lease as an executory contract or
recognizes an asset and liability depending upon the classification of the
lease contract. Lessor accounting similarly depends upon the lease
classification.
The IASB tentatively concluded
that the right-of-use (contract based) approach is the only approach that
results in the recognition of the assets and liabilities identified in a simple
lease. Under the right-of-use (contract based) approach, the capital and
operating lease distinction would disappear and most leases would qualify for
recognition as assets and liabilities by the lessee. As a result, the changes
in the standards would be very different from current recognition and
measurement standards.
