Question

Write about the changes in accounting for leasing. It used to be capital vs operating leases with the 4-part test. What is it now? How might it impact companies' financial reporting and the perception investors and creditors have of their business? Also, from a finance perspective, what are the pros and cons of leasing vs. buying outright?

Address this to me - not a fictitious business owner; try to teach me something and help me draw conclusions.

Answer 1

Agencies may enter into contractual arrangements (called leases) that allow for the use of property or

equipment over a period of time in exchange for a series of payments. PeopleSoft’s Asset Management (AM)

Module allows agencies to manage leases within STAR and make the required periodic payments. AM also

contains functionality for developing entries and note disclosures required for GAAP reporting purposes.

LEASE ADMINISTRATION AND PAYMENTS:

Most operating leases pertain to the rental of space for state agency operations or copy machines. The

Division of Facilities Management (DFM) within DOA centrally administers building leases for the State. DFM uses ARCHIBUS software to manage their leases and will not be converting to STAR. As a result, the State Controller’s Office will rely on DFM to provide information required for the CAFR annually.

Capital leases typically pertain to acquiring expensive information systems, software or equipment for use in agency operations. State agencies may finance capital lease contracts through private vendors and make payments directly to those vendors (lessors). Alternatively, agencies may finance leases through Master Lease Certificates of Participation (COPs). The Capital Finance Office within DOA is responsible for issuing COPs which are issued pursuant to and secured by  

the master indenture among the lessor, U.S. Bank National Association, as trustee, and the lessee.

Leases prescribes the accounting policies and disclosures applicable to leases, both for lessees and lessors. Leases are required to be classified as either finance leases (which transfer substantially all the risks and rewards of ownership, and give rise to asset and liability recognition by the lessee and a receivable by the lessor) and operating leases (which result in expense recognition by the lessee, with the asset remaining recognised by the lessor).

Capital Leases - Effects On:

Balance sheet - At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.

The discount rate used will be the lower of the following two rates:

The lessor's (the rental company's) implied rate The lessee incremental borrowing rate Going forward, the leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present.

Income statement - A capital-lease payment includes two components: one is the interest expense - which is included in the income statement but is not part of operating income (earnings before taxes from continuing operations) - and the second component is the principal payment, which is not included in the income statement . Instead depreciation expenses are included in income statement which are part of operating income. The interest portion will be higher in the first few years of the lease, and is consistent with the interest expense of an amortized loan. Total income over the life of the leased assets will be the same for operating and capital leases.

Cash flow statement - Total cash flow statements remain unaffected by operating and capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease expense. The principal payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO and understate CFF.

Operating Leases - Effects On:

Balance sheet - No assets or liabilities are recorded.

Income statement - The operating-lease payment will be treated as an operating expense.

Cash flow statement - Cash flow from operations will include the total lease payment for the specified accounting period.