Standard setters recognize that assets and liabilities might be improperly recorded in the financial position statements when leases are concerned. These records are prone to misleading information that may not be honest representations of the leasing transactions (Accounting for leases, 2019). The setters thus decided to introduce a single lessee accounting model, where the lease would be classified depending on whether the risks, rewards, and rights are eventually passed over to the lessee.
The accounting of leases assumes substance over form, meaning the commercial value is preferred to the legal form of an asset which may hide the nature of the transaction and may not be a comprehensive representation. Traditionally, leased items were not recorded in statements of financial position which meant charges that were associated with the asset were also unrecorded (Accounting for leases, 2019). This ‘off-balance sheet’ financing misrepresented the transactions since the companies may have owned assets or owed liabilities.
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If the lessor finances the leased asset while the other rights of ownership are carried over to the lessee, then the lease is defined as a capital lease (Capital and Operating Lease, 2019). Capital leases cater for non-current assets which eventually offer the lessee ownership rights (Capital and Operating Lease, 2019). In the general ledger, the asset is entered as property (a fixed asset) and the interest appears under expenses in income statements. The current market value appears on the balance sheet as an asset while depreciation is recorded on income statements as depreciation expense (Accounting for leases, 2019). The net current value of subsequent payments is recorded as a liability in the balance sheet as loan amount.
This differs from the operating lease which records the amount of the entire lease payment as an expense. Operating leases mainly cater to short-term leases and no handover of ownership rights is expected when the lease is over (Capital and Operating Lease, 2019). The perpetual payments which enter income statements as operating costs affect only the operating and net incomes.
Currently, leases are classified under the IAS 17. This classification is dependent on risks and rewards that result from ownership rights, and whether these get handed over once the stated period is over (Lease - operating or finance, 2019). The criteria for determining the nature of the lease requires a set of conditions to be checked (financial leases need to satisfy all the conditions).
The lease should hand the rights of the assets from the lessor when the lease period ends. If the lessor can sell the assets when the lease period terminates, then the lease would be an operating lease.
If the title of the asset is not handed over, the lease period has to encompass the greater part of the asset’s economic life. If it still has considerable economic life remaining when the lease period terminates, then that would indicate an operating lease (Lease - operating or finance, 2019).
The current value the least lease payment has should amount to the asset’s fair value at the inception of the lease. If payments do not sum up to the asset’s fair value, then that indicates the lease is an operating lease (Accounting for leases, 2019).
The leased asset has to be specialized. In case of an operating lease, the lessor can lease non-specialized assets elsewhere when the lease period terminates, and they also bear this risk.
In case the lessee is allowed to cancel the lease, they have to bear the lessor’s loss that results from this cancellation.
Profits (as well as losses) due to variations in the asset residual are fair value are borne by the lessee. If the lessor holds gains from the subsequent sale and also bears the residual value risk, then that would be an indicator of an operational lease.
The lessee may continue their lease for the asset for a subsequent period at rates that are lesser than the current market rents. The lessor may, alternatively, extend the lease at market value, indicating that they have not achieved the return on investment and are relying on subsequent lease. This would then characterize an operating lease.
Companies recording their financial statements have to modify the values stated in their financial position statements to show the assets and liabilities that result from leases. This, however, seems to counter the need to undertake the initial process of classifying the type of lease a company opts for. The current model seems to lack comparability due to the difficulty and the complexity differentiating between the two types of leases. The new leasing rules provide more accurate representations of companies’ financial positions.
References
Accounting for leases | F7 Financial Reporting | ACCA Qualification | Students | ACCA Global. (2019). Retrieved 13 August 2019, from https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-resources/f7/technical-articles/accounting-for-leases.html
Lease - operating or finance | ACCA Qualification | Students | ACCA | ACCA Global. (2019). Retrieved 13 August 2019, from https://www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-resources/f7/technical-articles/lease.html
Capital Lease vs Operating Lease - What You Need to Know. (2019). Retrieved 13 August 2019, from https://corporatefinanceinstitute.com/resources/knowledge/accounting/capital-lease-vs-operating-lease/
