Question

1.  Under current accounting rules, what are the financial reporting differences between an operating lease and a capital lease? How will this change with the new accounting rules effective in 2019/2020?

2. Are current footnote disclosures sufficient to overcome nonrecognition on the balance sheet of assets and related liabilities for operating leases? Explain.

3. Is the expense of a lease over its entire life the same whether or not it is capitalized? Explain.

Answer 1

1.

Operating Vs Finance leases

• Title: In a finance lease agreement, ownership of the property is transferred to the lessee at the end of the lease term. But, in operating lease agreement, the ownership of the property is retained during and after the lease term by the lessor.
• Balloon/residual amount: In finance lease agreement, there is a balloon/residual option for the lessee to purchase the property or equipment at a specific price. But, under an operating lease, the lessee does not have this option. The balloon/residual on a finance lease is set using ATO asset guidelines.
• Running costs & administration: Under an operating lease all running costs (servicing, registration, tyres, insurance etc) are included in the lease within the designated term and usage km with one set monthly repayment amount. Under a finance lease these are generally not included meaning there can be greater administration and price fluctuation for the lessee.
• Account treatment: Operating lease are treated as expenses (ie off balance sheet items) where as a finance lease is included as an asset for the lessee

The IASB published IFRS 16 Leases in January 2016 with an effective date of 1 January 2019. The new standard requires lessees to recognise nearly all leases on the balance sheet which will reflect their right to use an asset for a period of time and the associated liability for payments.

2.

IFRS 16 Leases was issued in January 2016 and is effective for annual reporting periods starting on or after 1 January 2019. It replaces IAS 17 Leases and related Interpretations.

IFRS 16 changes the accounting substantially for lessees. The new Standard eliminates a lessee’s classification of leases as either operating leases or finance leases. Instead, almost all leases are ‘capitalised’ by recognising a lease liability and right-of-use asset on the balance sheet. There is little change for lessors.

Leasing is a common form of finance. The Effects Analysis, published alongside the Standard in 2016, described the likely costs and benefits of IFRS 16. This analysis estimated that listed companies around the world have around $3 trillion worth of future payments for leases, which were not recognised on the balance sheet applying the previous accounting requirements.

IFRS 16 will increase visibility of companies’ lease commitments and better reflect economic reality. The Standard will also make it easier for users of financial statements to compare companies that lease their assets with companies that borrow money to buy their assets, creating a more level playing field.

3.Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same whether or not the lease is capitalized.

• The capitalized lease method is an accounting approach that posts a company's lease obligation as an asset on the balance sheet.
• A lessee must capitalize leased assets if the lease contract entered into satisfies at least one of the four criteria published by the Financial Accounting Standards Board (FASB).
• An operating lease expenses the lease payments immediately, but a capitalized lease delays recognition of the expense.

While an operating lease expenses the lease payments immediately, a capitalized lease delays recognition of the expense. In essence, a capital lease is considered a purchase of an asset, while an operating lease is handled as a true lease under generally accepted accounting principles (GAAP).

When a lease is capitalized, the lessee creates an asset account for the leased item, and the asset value on the balance sheet is the lesser of the fair market value or the present value of the lease payments. The lessee also posts a lease obligation in the liability section of the balance sheet for the same dollar amount as the asset. Over time, the leased asset is depreciated and the book value declines.

A lessee must capitalize a leased asset if the lease contract entered into satisfies at least one of the four criteria published by the Financial Accounting Standards Board (FASB). An asset should be capitalized if:

• The lessee automatically gains ownership of the asset at the end of the lease.
• The lessee can buy the asset at a bargain price at the end of the lease.
• The lease runs for 75% or more of the asset's useful life.
• The present value of the lease payments is at least 90% of the asset's fair market value when the lease is created.

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