As the IASB-FASB joint international working group began its study of lease accounting in late 2006 and early 2007, it had a number of staff documents prepared

As the IASB-FASB joint international working group began its study of lease accounting in late 2006 and early 2007, it had a number of staff documents prepared to help observers at their meetings follow the working group’s discussions. These documents are available on the IASB website (www.iasb.org) by following the “Projects” link for “Leases.” They cover a wealth of information, including the results of prior academic research on lease accounting and its potential implications for the lease accounting project. Obtain the Information for Observers document for the February 15, 2007 and March 22, 2007 meetings of the IASB-FASB joint committee that deals with academic research on lease accounting. Alternatively, research and read up on the academic accounting literature on lease accounting.

Instructions

(a) Summarize the issues that have been addressed by academic research on lease accounting.

(b) In general, what were the findings of this research on each issue?

(c) Identify what the implications are of the research findings for the development of new accounting standards for leases.

(a)    The issues that have been addressed by academic research on lease accounting are as follows:

·    To what extent would recognition of off-balance sheet leases affect financial statements, and which industries would be most affected?

·    What is the relationship between leases and other forms of financing, including debt and equity? How do leases, in conjunction with debt, affect equity risk?

·    How is lease accounting information perceived or used by investors, creditors, and other financial statement users?

·    What was the impact of Statement of Financial Accounting Standards 13 on market assessments of risk and profitability and on the use of leases relative to other types of financing?

(b)    The findings of the research on each issue are presented below.

·      The impact of capitalizing leases

            i.      Balance sheet measures such as gearing or leverage ratios would be significantly increased by capitalization of operating leases.

          ii.      Performance measures such as profit margin, return on assets, and asset turnover would also be affected by capitalization of operating leases, although not as dramatically as balance sheet measures.

        iii.      The impact on balance sheet and performance measures would be most pronounced for service industry firms such as airlines, hotels, retailers, media agencies, and vehicle distributors.

          iv.      Capitalization of operating leases would likely alter the relative standing of firms within and across industries for gearing and other debt-related ratios. In contrast, capitalization of operating leases is not as likely to alter the relative standing of firms for performance measures, within or across industries.

·    The similarity between operating leases and debt

       i.      Disclosed capital leases under ASR 147 are positively associated with equity risk, after controlling for debt levels (which also are associated with equity risk).

     ii.      The present value of operating leases (calculated using a typical present value approach or a factor approach) also is positively associated with equity risk, after controlling for debt levels.

   iii.      Amounts paid under contingent fee lease arrangements are not associated with equity risk, suggesting that the contingent fee component of lease payments does not behave like debt in its effect on equity risk.

     iv.      Leases (operating leases in particular) appear to be partial substitutes for debt financing, with leases partially consuming debt capacity.

·    How lease accounting information is used

            i.      Lending officers are willing to lend at lower rates and assign higher credit ratings to firms that use more operating leases than capital leases, suggesting either that lenders perceive capital leases and operating leases to be economically different, or that lenders are misled by the accounting.

          ii.      At least one credit rating firm consistently adjusts its debt and leverage analyses to recognize the present value of operating leases, suggesting that it considers operating leases to be equivalent to debt.

        iii.      Stockbroker analysts do not appear to capitalize operating leases when performing stock valuation or forecasting.

          iv.      Users and preparers often hold quite distinct views on how to account for leases. However, they both seem to agree on some important issues as well.

·    The impact of SFAS 13

            i.      The market’s assessment of firms’ equity risk did not change following the adoption of SFAS 13. This result holds for numerous measurements of equity risk across multiple industries.

          ii.      In a side-by-side comparison of identical firms that differ only in their use of capital or operating leases, CFOs, bank lenders, auditors, bond analysts, and stock analysts tend to prefer the operating-lease firm over the capital-lease firm on metrics such as profitability, ability to repay, and ability to predict cash flows. This result seems at odds with the finding that SFAS 13 had no impact on firms’ equity risk, but this difference may have occurred because participants in these studies were assessing more than just equity risk when expressing a preference for the operating-lease firm over the capital-lease firm.

        iii.      Firms mitigated the impact of SFAS 13 by renegotiating the terms of lease contracts to avoid capital lease criteria. Firms also shifted their financing away from fixed-price financing toward equity financing. This result was documented in the United States and in Australia in response to the issuance of their respective lease accounting standards.

          iv.      Stock prices declined for firms that would have experienced tightened debt covenant restrictions as a result of SFAS 13. The magnitude of the stock price decline was positively associated with the change in the tightness in debt covenant restrictions that would have resulted.

            v.      No other stock price reactions to events leading up to the issuance of SFAS 13 have been documented, suggesting the possibility that the market’s reaction to any new lease accounting standard also would be minimal.

(c)    Identify what the implications are of the research findings for the development of new accounting standards for leases.

Based on these studies and other opinions, the IASB considered various accounting models for lease accounting. It discussed

·         the right-of-use (contract based) approach. In this approach, the lessee recognizes its right to use the leased item and an obligation to pay for that item. The lessor recognizes, as an asset, its right to receive payments from the lessee and its residual interest in the leased item at the end of the lease.

·         the whole asset model. In this approach, the lessee records the whole of the physical item on its balance sheet. To correspond to that asset, the lessee recognizes two liabilities: the obligation to make payments to the lessor and an obligation to return the physical item at the end of the lease. The lessor recognizes its right to receive payments from the lessee and its right to have the leased item returned at the end of the lease.

·         the executory contract model. In this approach, the lessee recognizes no assets or liabilities upon entering into the lease contract. Lease rentals are recognised in profit or loss as they become due. The lessor recognizes the leased item as an asset.

·         the model used in current standards. The lessee either accounts for the lease as an executory contract or recognizes an asset and liability depending upon the classification of the lease contract. Lessor accounting similarly depends upon the lease classification.

The IASB tentatively concluded that the right-of-use (contract based) approach is the only approach that results in the recognition of the assets and liabilities identified in a simple lease. Under the right-of-use (contract based) approach, the capital and operating lease distinction would disappear and most leases would qualify for recognition as assets and liabilities by the lessee. As a result, the changes in the standards would be very different from current recognition and measurement standards.