Asset not Recorded on Balance Sheet - Essay Example

Asset not recorded on Balance Sheet The increasing internationalisation of businesses has enhanced the importance of international accounting standards for reporting the items on financial statements. The international bodies like IASB and FASB are playing an important role in defining the accounting and reporting standards. The accounting standards explicitly elaborate the definitions, inclusion and exclusion criteria and other related information about each item of financial statements. A simple view of balance sheet is that it contains assets, liabilities and owners’ equity however; companies face various complexities while developing these statements because there are various rules, which have to be considered before reporting any item on financial statements. In 1993, SNA categorised assets reported on the balance sheet as economic assets and these assets were defined as the entities on the balance sheet over which ownership rights are imposed and from which the owners can get the economic benefits by using and holding them for a period (Harrison, 2006).1 The companies have to follow the criteria defined by internal accounting regulatory authorities to report the assets on their balance sheets and the same criterion is used for the exclusions of assets. It means, there are various cases in which the assets are not reported on the balance sheet. An example of the assets, which are not reported on a company’s balance sheet are the off balance sheet assets. Actually, in the off balance sheet financing the company is able to use the assets without recognising them on the balance sheet. The off balance sheet includes asset or debt such as a lease or a contingent liability. Moreover, off balance sheet may also include forwards, futures, letter of credit, loan commitments and derivatives. Most of the financial institutions have significant portions of off balance sheet assets because they offer asset management or brokerage services to their customers. The off balance sheet assets usually include the securities that generally belong to the customers of the institution and the institution may provide depository, management or other relevant services to the client. A financial institution does not have direct claim on off balance sheet assets. Operating lease is the most suitable illustration of off balance sheet assets. Operating lease is an off balance sheet activity in which every month, the rental payment of using equipment is expensed out from the income statement. Moreover, neither the value of asset nor the associated liability is placed on balance sheet. This is the major difference, which makes the capital lease different from the operating lease. Since, the liability is not reported on the balance sheet, therefore, because of the double entry system, the asset is also not entered. However, for any lease to be an operating lease there is a specific criterion that must be met.2 It is very important to understand the rationale because of which the companies opt for off balance sheet financing. The first reason is that off balance sheet financing reduces the liabilities on the balance sheet thereby, attracting more and more lenders. Second, off balance sheet financing allows the companies to avoid the violation of some debt covenants.3 Third, companies seek to present their balance sheet with considerable liquidity and less indebtedness. Moreover, companies may face higher cost of equity capital and decline in stock prices because of excessive leverage on their balance sheets. That is why companies are always motivated to opt for off balance sheet reporting methods. Nowadays, companies are following properly defined standards for reporting off balance sheet operating leases, however, before that firms used to account them in whatever manner best helped them. In 1976, FASB 13 was issued, in which the standards for lease accounting and reporting were introduced.4 Today, the companies are following the standards of reporting operating lease, as defined by FASB 13. It also gives different classifications of leases, criterion to classify the lease, accounting and reporting methods for lessee, lessor, subleases and leveraged leases. The opponents of this accounting treatment of lease have proposed a new approach of lease accounting. The new approach is based on the fact that lease activities give rise to the right to use the asset and liabilities for future rental payments. Therefore, the assets and the liabilities should be recognised to ensure that leases are being accounted by all the firms in the industry. However, the proponents of FASB 13 are still in the favour of not reporting leased asset on balance sheet because this method allows the companies to show higher net operating asset turnover. Very recently, the International Accounting Standards Board (IASB) and the United States Financial Accounting Standard Board, have given a great focus towards modification of lease accounting rules related to the listings of the operating leases of the companies on their balance sheets. In 2007, the total reported volume of leasing was $760 billion and much of the volume was not reported on the balance sheets of the firms. The growing concerns raised by the users of financial statements such as investors regarding the accounting treatment of lease contracts under the U.S. Generally Accepted Accounting Principles (GAAP) and Financial Reporting Standards (IFRS), insisted the standard board to take serious actions regarding it.5 Today, the accounting and reporting method for leases are most benefiting the managers and most of the managers have been trying to avoid lease capitalisation. However, it is also true that the rules of reporting leases have been structured around strict requirements but the managers are able to structure their lease contracts to attain the desired accounting results. Read More