Controversy Over Accounting Leases

New Rules for Lease Accounting: The Controversy The Accounting Lease Controversy The Advantages of the new system Voices Against the New Lease Accounting Model The Accounting Lease Controversy The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) jointly issued exposure drafts on August 17, 2010 proposing a new lease accounting paradigm. The EDs propose changes to simplify lease accounting and improve transparency.

The new lease accounting model is based on the core principle that all leases gives rise to liabilities for future rental payments and assets that should be reported on the entity's balance sheet. The objective of the new approach is to ensure consistent lease accounting across sectors and comparability of financial reporting. This paper analyzes the economic impact of the proposed new lease accounting paradigm on the financial statements and derived financial ratios of the reporting entity (Accountancyage.com).

In 2013, the lease accounting world underwent a big change that has given rise to a controversy that is still raging on. The controversy is about whether to adopt the new system to lease accounting or not and whether it would be beneficial to the companies, firms, business organizations and accounting world. Prior to the proposed new system, companies and business organizations were able to classify almost all the leases and lease agreements as operating leases and were thus able to not show them on their balance sheets.

This is an established principle that the regulators and accounting critics have been criticizing for long. One examples that the critics put forward is in the case of airlines where airline companies put out all their airplanes on lease and then they do not show details or even mention these lease on the balance sheets as assets and therefore they also do not also show the money that the companies are liable to play in the future for the commitment to pay for the planes.

There have been hue and cry to remove this defect from the accounting system of leases and lease agreements and the showing of lease as assets I the balance sheets of companies which would give a better understanding of the liabilities of the companies and the gains made by the companies (Accountancyage.com).

Proponents of this new system that is aimed for the development of an improved standard for leasing is vital as the investors and the shareholders in companies are forced to take educated guesses about the liabilities that are hidden beyond what is revealed in the balance sheets of companies and business organizations that account from leasing activities.

The new rules for examples, would require an airline that has entered into a lease for a plane to identify and show the leased plane as an asset in the balance sheet and the right to use the plane along with the equal liability based on the current value of the lease payments that the airline has promised to make to the company from which it has leased the aircrafts.

This would be similar to money being borrowed for business and which are mandatorily exhibited in the accounts and balance sheets (Bauman and Francis). This format of accounting would enable the shareholders and the investors know the exact figure that the airline would owe to other companies and entities and thus make a far better judgment of the liability that is associated with the entire operations of the airline. Similar conditions are applicable for other business and their investors and shareholders.

This proposal for the accounting of lease has been long demanded by investors who want companies to show leases as liabilities and as such, those liabilities should be reflected on the balance sheets of companies. There are however a number of critics to the new system of lease accounting.

While the critics agree that there was need for making some improvements in the accounting system for lease and lease agreements, the process needed to be slow and delayed to enable the companies, and business organizations to adapt suitably to the new system of regulations. It is expected that the new rules and regulations for lease accounting should be effective from 2017 to give companies time to comply and, in some cases, to renegotiate loan agreements so that the companies are in a better position to negotiate limitations of loans.

Under the new system, income statements for many companies would also undergo changes apart from making balance sheets larger. For example, if a company leased a piece of machinery for $1,000 a year for five years, the company would have to show just expenses of $1,000 every year. Under the new system, a larger expense in early years would have to be showed by the company against the leased machinery and subsequently smaller ones in later years.

This is because the new system of accounting considers the lease expenditures to be similar in nature of the company had taken a loan or borrowed money from the market to purchase and asset and would have to pay off the loan in equal sums of money over a period of five years. In the earlier formats the interest expense would be higher than in later ones (Bauman and Francis). The accounting of lease and lease agreements in the case of real estate would be a little different.

Even as leases would be put in the balance sheets as assets the value of the lease would be based on the expected lease payments over the entire period of the lease. This rules out the considerations for renewal and the costs and prices involved in it unless it is assumed that the renewal would be at such favorable prices that it would act as a significant financial incentive to renew.

In the cases of any variable basis for the calculations of the lease payment, the value would not reflect the expected additional payments as is with the case of a store lease that has two components, the lease amount and a percentage of sales. This would help in keeping the value of the asset as well as the related debt at a lower scale than otherwise (Cheng). The Advantages of the new system The new system would help in determining the Lease Term accurately.

The longest possible term for a lease that is more likely than not to occur is defined by the proposed new standard for accounting of lease and lease agreements. This also considers the effect that can emanate from the options for the extension or termination of the lease and the lease agreement. There are possibilities that leases could entail several clauses that can include unfavorable renewal options, penalties for early termination of the lease agreement and a combination of a renewal option and a residual value guarantee.

There uncertainties are taken care of in the proposed new accounting standards for lease. The lease agreement or the contract, for examples, may have options of the leased asset to be renewed and the user continues using the asset or returning the asset back to the owner at the end of the original lease term.

In such contracts there can be, as is often the case, that the lessee pay the lessor the difference between the expected residual value and the actual residual value in case the lessee decides to hand over the asset to the lessor at the end of the contract period.

The new format allows taking into account the assessment by the lessee and lessor at inception of the lease agreement whether it is more likely than not that the lessee and the lessor would agree to the extension of the contract at the end of the contract period.

Estimation of a probability of occurrence for each possible lease term -- in cases of the leases renewal, early termination of the contract or a combination of renewal and residual value guarantees, and a calculation needs to be made about the expected outcome to derive from the use of the asset during the ease term and the discount of the future lease payments.

The assessment and the reassessment of this aspect requires to take in to consideration the expected outcome that is more likely than not to occur at each reporting date where assumptions are based in any new facts or circumstances that can indicate any significant change in the earlier assumptions. The new proposal makes possible the following considerations in the making of assessment of the probability for each of the possible end of lease term options.

The level of lease payments, bargaining for renewal options, penalties for termination of the contract and the contingent rental payments are taking into account as part of the contractual factors. The influence of the local regulations, costs for relocation of the leased asset and any significant improvement in the existing leasehold and such non-contractual factors are taken into account in the new accounting system (Bauman and Francis).

The significance of the impact on the lessee's operations by the underlying asset and whether the asset has a specialized value for the lessee are business aspects that are taken into account and are reflected in the balance sheet while determination of the lease term. Other aspects that have financial value like the past practice of the lessee or the lessor and the intentions are also accounted for.

This makes the calculations of the actual lease term accurate and would help investors and shareholders understand the value and the details of the lease to make and assessment of the associated liability (Icaew.com). Lease Payments The proposed standard would derive the lease liability by including contingent rental payments even for those lessees who, even under the present system, account for leases as capital leases.

The new proposal for lease accounting would enable the assumptions and calculations on the basis of an accurate lease term determination, the expected outcome and the option for renewal or penalties. Therefore the new system would allow the accountants, the investors and the regulators as well as the leasing companies making accurate valuations for the lease assets and liability on the statement of financial position for lessees. The payments for leases are determined on the basis of an expected outcome.

To accurately calculate the expected outcomes it is necessary to identify each reasonably possible outcome and the amount and timing of the cash flows needs to be estimated for each reasonably possible outcome. To have an idea of the liability and the actual impact of the asset on the company, it is also necessary to calculate the present value of the cash flows and make and assessment of the probability of each outcome.

This would give the investors a very clear about the financial impact of a leased asset for the future. Based on the expected outcome, a lessee will be able to determine the present value of lease payments that would need to be undertaken during the lease term. The present value of the probability-weighted mean of the cash flows for the reasonably possible outcomes is the expected outcome.

The present value for a lease also is calculated accurately in the new accounting system where issues like contingent rental payments, estimated future payments under the residual value guarantees and the estimated expected payments under term option penalties are used (Durocher and Fortin).

Thus the new system of accounting for lease allows companies to accurately determine the lease term based on the various possible end of the term pr contract outcome as well as calculate value of lease agreements in accurate manner based on the present value of lease agreements, the present and expected cash flows and the end value of the outcome of the lease.

Helps in Accurate Cost Benefit Analysis for the investors Providing information that is useful to investors and creditors for decision making is the primary objective of financial reporting. Relevance and reliability are the two qualities that are necessary to insure an efficient decision that can be effectively utilized (Kusano, Sakuma and Tsunogaya). The new model and the proposal for the accounting of lease are better in exhibiting critical financial information to the investors and is an improvement over existing lease accounting rules.

The significant improvements that have would be made possible due to the new accounting of lease model would include increase in accuracy, greater representational faithfulness and enhanced comparability between entities. The new systems benefits the users as they would no longer have to make adjustments to operating lease information and depend on subjective methods of adjustment that are made by analysts using estimates.

As mentioned above, the users and investors would be able to benefit from the better information about the expected cash flows since in the new system, the effects of contingent features and amounts payable in optional periods have been included in the lessee assets and liabilities. There has always been concern among analysts about the difficulty in the determination of lease terms and the expected lease payments (Norris).

However there have been some opposition from a section of the business who acclaimed that for an entity with a large volume of small leases with different terms and with limited resources, it would have significant administrative costs and it would also be difficult to determine an appropriate discount rate for each lease contracts and the liability measurement on an amortized cost basis.

However despite these voices of opposition the new system claims that the new model would include the costs of financial reporting in the new system for reporting entities. However what ruled the new system in favor of the older system is the costs that the users have to incur when needed information is not available in the financial statements and when it becomes critical for the investors and other users of financial data to obtain the data on their own or from other sources.

And even after expending finances and time in gathering the information, more often than not, the basis of such data and estimates are more subjective and less reliable (Norris). The efficiency of the capital markets would be improved as the financial statement users would greatly benefit from the improved financial reporting even as the implementation costs of the proposed model would not be borne evenly. Voices Against the New Lease Accounting Model There is a section of the business who are opposing the new system of accounting for leases.

The primary concern for the business and a section of the accounting world is that the new system would add hundreds of billions of dollars in debt to the companies' balance sheets. The new rules and regulations are being opposed on the grounds that the system would alter the process some companies follow to account for the costs of leases in their earnings and the banks would be forced to recognize many leases on their balance sheets which are not present o the balance sheet (Singh).

The majority of opposition is coming from the heavy users of leases such as retail and restaurant chains, airlines and companies that lease office equipment. The critics of the new system also say that too complicated and burdensome have been proposed in the new system and taking into account the costs for the additional financial reporting, it would hurt more than help. The critics point out that the.