1. Accounting Treatments
Capital Lease -Lessee
Initially, the lessee recognizes the asset under his property, plant and equipment. The amount that should be debited is the Lower of asset’s fair value and present value of minimum lease payments. The present value is determined by discounting minimum lease payments using interest rates implicit in the lease. Also, initial direct cost that the lessee incurs in relation to the lease is added to the cost of recognized asset. On the credit side of the entry should be lease liabilities, which is in fact, some kind of a loan. The lease liabilities should be split into current and noncurrent liabilities as some payments are made within 12 months while others are made after 12 month of the reporting date. Subsequently, there are two things we must take care of. First, we must depreciate the lease asset over the economic life, not over the lease term because that doesn’t necessarily need to be the same. The entry is to debit depreciation expense in profit or loss and credit the accumulated depreciation account. Secondly, we need to allocate the lease liability or minimum lease payments paid to the lessor into two parts; reduction of lease liability and finance charge or interest. IAS 17 requires the finance charge to be allocated so as to produce a constant periodic rate of interest (interest rate implicit in the lease) on the remaining balance sheet liability. (Refer to appendix A for journal entries Capital lease-Lessor
The lessor is a finance provider, and therefore records lease receivables as the debit side of the entry. The lease receivable is the net investment in the lease, which is the total of minimum lease payments and unguaranteed residual value. Total of these two figures is gross investment in the lease and we need to discount it to present value using discount rate implicit in the lease and all this must be equal to fair value of the asset plus initial direct cost. The credit side to this entry is simply cash given out by the lessor. Subsequently, we have to split minimum lease payments received from the lessee between reduction of finance lease receivable and finance income similar to what the lessee would do. (Finance income should reflect a constant periodic rate of return on the lessor’s net investment in the lease.) (Refer to appendix A for journal entries) Operating Lease-Lessee
In an operating lease, the lessee does not recognize any asset. The lease payments are recognized as rent expense in profit or loss on a straight-line basis. The journal entries would include a debit to rent expense and credit to cash or accounts payable. (Refer to appendix A for journal entries) Operating -lessor
Lease payments received from the lessee are recognized as revenue in profit or loss on a straight-line basis. The lessor keeps the asset on his financial statement and depreciates it in line with its fixed asset accounting policy. (Refer to appendix A for journal entries) Advantages of Operating Lease
In an operating lease, the lessee is considered to be renting the equipment and thus the lease payment is recorded as rental expense. No assets or liabilities are recorded on the balance sheet (Off-balance sheet financing). This is beneficial for companies because it will result in a lower asset base, therefore creating a higher ROA. Operating lease will also display more desirable solvency ratios such as lower debt to equity. This off balance sheet method of recording will also produce better debt covenant ratios for the company to show its debt lenders. Moreover, some companies associate management bonuses to certain ratios such as return on capital, which would be more optimal looking if recorded under operating lease. Another major benefit of operating leases is the potential tax benefits. An operating lease may allow the company to deduct payments as operating expenses during the period in which they are paid. If the company purchases equipment, they may be able to deduct the interest, as well as the cost of the depreciation.
2. Under current Financial Accounting Standards Board regulations, what business arrangements might FedEx have made in order to account for leases as operating leases rather than capital leases? An operating lease is usually coined as anything that is not classified as a finance lease. Factors that an operating lease may include are: 1. If a lease does not significantly transfer all the risks and rewards, associated with ownership of an asset the lease 2. If the ownership of the asset is more likely to go back to lessor at the end of the term 3. The lessee does not have the option to buy the asset at a cost significantly below the fair value of the asset → ie. a bargain price. The term of the lease is not a major part of the economic life of the lease item. IAS 17 does not explicitly say how much is a major portion however ASPE states that 75% and above is a major portion. 5. If there is little or no risk to the lessee; all major risks are borne by the lessor. An example would be cancellation costs. 6. The leased asset is of common nature; not specialized and can only be used by the lessee. 7. The present value of the total amount of minimum lease payments do not equal or is close to the fair value of the asset leased. Other Additional Criteria can be:
8. Whether fluctuation in fair value at the end of the lease accrue to the lessor 9. If the lessee does not have the option to extend the lease for a secondary period at a “below the market” price Arrangements FedEx would have to make to disclose the operating lease would include disclosures about: the outstanding payments left for non-cancellable operating leases for the time periods: within one year
within two to five years
after more than five years
the total future minimum sublease income for non-cancellable subleases the lease and sublease payments recognised in income for the period the contingent rent recognised as an expense the general description of significant leasing arrangements, including contingent rent provisions, renewal or purchase options, and restrictions imposed on dividends, borrowings, or further leasing For operating leases, IAS 17 states that the total lease payments should be incurred as an expense and would appear on the income statement regularly with the amount on a straight-line basis over the entire lease term. Any enticements that the lessee may have received from the lessor to enter into the lease arrangement, must also be divided on a straight line basis to offset the rental expense.
4. Lease Capitalization on Financial Variable and Ratios
Unrecorded Lease Liability and Debt-to-Equity Ratio Based on the ratios and calculations performed there are many incentives for companies to report leases as operating leases rather than capitalize them. It can be concluded that the impact of lease capitalization on the financial statements is far greater for FedEx than UPS, however both companies are reaping benefits from reporting leases as operating leases. Capitalizing leases requires that leases are recorded as assets and liabilities on the balance sheet. The Unrecorded Lease Liability is 98.41% of existing liabilities for FedEx and 8.27% for UPS. Thus, by not capitalizing leases, firms are able to decrease their liabilities and present a more lower debt/equity ratio.The Debt/Equity ratio gives stakeholders an indication of the capital structure of the firm. The ratio for FedEx moves from 0.97 to 2.70, which indicates a more leveraged capital structure. UPS ratio moves from 0.87 to 1.28. The capitalization of leases would not allow FedEx to maintain a debt-equity ratio below 1, which would change shareholder’s view on the financial flexibility of the firm.
If FedEx wishes to maintain a relatively low debt-to-equity ratio on their financial statements it would be unfavourable to capitalize leases. Return on Asset The Return on Assets (ROA) is another key ratio that is affected when leases are capitalized due to the increase in assets that the company owns. When leases are capitalized there is a decrease in ROA for both FedEx and UPS by 1.69% and 0.32%, respectively. This is a relatively significant drop in efficiency and further motivates firms to record leases as operating leases. Interest Coverage Ratio The interest coverage ratio informs stakeholders of a company’s ability to pay back their interest. There is a significant drop of 17.26 in FedEx’s interest-coverage ratio and a drop of 9.2 in UPS’s interest coverage ratio. This means that a certain amount of profit is attributed to the fact that leases are not capitalized.
In conclusion, it is clear from the variables and the ratios analyzed why companies prefer to record leases as operating leases rather than capitalize them. Operating leases are kept off the balance sheet and their main impact on the income statement is rent expense since the risks of ownership are not assumed. On the other hand, when leases are capitalized, the present value of payments including interest expense, is treated as a liability on the balance sheet. These two accounting methods result in ratios to be more favourable for the firm when leases are recorded as operating leases rather than financial leases. 5. New Exposure Draft: A Contract-Based Approach
Development of Contract-Based Approach Leasing is a critical activity in business as it is a means of gaining access to assets, obtaining finance and reducing an entity’s exposure to the risks of asset ownership. Some key advantages of leasing assets rather than purchasing assets are 100% financing, flexibility and the tax advantages. Therefore it is crucial that leases are appropriately accounted for and nature and duration of the lease agreement is considered. Current models require lessees and lessors to account for leases as either finance leases or operating leases. A recurring criticism of this approach is that lessees are not required to recognize assets and liabilities arising from operating leases. We can see the benefits of this in the financial statements and ratios of FedEx and UPS, as discussed above. In our opinion capitalizing leases provides stakeholders of a less aggressive view of a company’s financial statements. The contract based approach ensures that companies recognise the right to use an asset along with the contractual liability on its balance sheet. Recognition and Measurement (Lessee) IASB and FASB are proposing a new approach to lease accounting that ensures entities record assets and liabilities arising from a lease.
With this new approach, a lessee would recognize assets and liabilities for leases with a maximum possible term of more than 12 months. Under this contract-based approach, the asset is taken on by the lessee as the right to use to asset and not the asset itself. This a key difference between the contract-based approach and finance leases. When the lease is acquired, the lessee would recognise a lease liability. This would refer to the obligation of the lessee to make recurring lease payments. Additionally, the lessee would recognize a right-of-use asset representing a lessee’s right to use the underlying asset for the lease term. The right-of-use asset would include the initial measurement of the lease liability, any lease payments made at or before commencement date and any initial direct costs incurred by the lessee. The proposal further categorizes the leases into Type A and Type B leases. Type A Lease Recognition Leased assets other than property (such as equipment and vehicles) would be classified as a Type A lease. However, if the following two conditions are met, the lease would be classified as a Type B: if the lease term is an insignificant portion of the asset’s economic life and if the present value of the lease payments is insignificant relative to their fair value. Initial measurements for a Type A lease would include a right-of-use asset and a lease liability.
The lease liability would be measured at the present value of the lease payments, measured at the rate charged by the lessor. If that rate cannot be immediately determined, the lessee uses the incremental borrowing rate. Subsequent measurements would recognize interest expense and the amortization of the right-of-use asset separately on the income statement and balance sheet. This would be accounted for separately from the amortization of the asset. Type B Lease Recognition Leased assets of property (such as land or a building) would be classified as Type B leases. Initial measurements would be parallel to the initial measurements of Type A assets. However, subsequent measurements would recognize a single lease cost. This cost would be a measurement of the interest expense as well as the amortization of the asset. This combined figure would be calculated on a straight-line basis. Effect on Existing Operating Lease Existing operating leases must be appropriately treated based on the accounting standards for leases.
Leases that were previously reported as operating leases by lessees should be recognised using the new approach at the beginning of the earliest comparative period. The lessee should recognize the lease liability, which is the present value of the remaining lease payments. For Type A leases, a right-of-use asset is measured as a proportion of the lease liability. The proportion is based on the remaining lease term at the time of the earliest comparative period. Additionally, the right-of-use asset recorded should be adjusted for any previously recognised prepaid or accrued lease payments. On the other hand, for Type B leases, a right-of-use asset is measured at an amount that equals the lease liability. The asset is then adjusted for previously recognised prepaid or accrued lease payments.