The Theoretical Basis for the Accounting Standard - Essay Example

?Part 1a The theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee is based on the notion that a lease that transfers to the lessee the risks and benefits of using an asset should be recorded as an acquisition of a long-term asset (Schroeder, Clark & Cathey, 2005).The lessee is expected to record the lease either as an asset or liability since this is more like a long term purchase that adds value to the property of the company which should be reflected in the balance sheet of the firm. b. At the inception of the lease, Lani should account for the lease as an asset which is determined by the value of the property. Thus, the amount to be recorded by the lessee should be equal to 75 percent or more of the estimated remaining economic life of the leased property. This is a long term purchase where the price value should be substantially lower than the market value which determines the amount to be recorded. c. During the first year of the lease, Lani is expected to incur expenses that equals or exceeds at least 90 per cent of the fair value of the property that is leased. Basically, these expenses are determined by the value of the property at inception of the lease and this value is agreed by both the lessee and lessor. d. Lani should report the lease transaction on its December 31, 2006, balance sheet as an acquisition of an asset. Virtually, a lease agreement transfers ownership of property to the lessee and this should be reflected on the balance sheet as purchase of assets which adds property value to the company. 2a. The criteria that must be met by Doherty Company to classify it as a capital lease is that it must transfer substantially all of the benefits and risks of the ownership of property to the lessee. If the agreement transfers the property rights to the lessee, then it will be classified as a capital leases given that it will be an acquisition of the property by the lessee. In this particular case, Doherty Company should transfer ownership to the lessee in order for it to classify it as a capital lease. b. In order for Lambert Company to classify the lease as a sales-type, it must be able to realise a profit from the lease or be able to determine if it is making a loss. In actual fact, Lambert Company as the lessor must be better positioned to generate some revenue that can contribute to the profit margins of the organisation. Lambert Company can classify this lease as direct financing lease if it does not record any profit from the lease. It will be widely viewed as a lending institution. c. The main difference between a sales type lease and a direct financing lease is that the main reason behind a sales lease is to realise profits while direct financing is not primarily concerned with profits but just revenue generation. Therefore, the purpose of the lease and the goals to be achieved are the major factors that make a distinction between the two. However, accounting steps for these two types of leases are just the same. Part 2 During the contemporary period, it can be noted that companies continue to acquire property to improve their operations. Leasing is an alternative means of acquiring long-term assets to be used by business firms (Schroeder, Clark & Cathey, 2005). Leases provide for the right for use of the property by the lessees since they are given the obligation to make a series of payments over a long period of time. As such, leases are similar to long-term debt which enables the lessee to utilise off-balance sheet financing. This paper therefore is mainly concerned with explaining the meaning of debt and equity financing in relation to lease verses purchase options. According to wisegeek, “debt financing is a way of raising some funds to generate working capital for the organisation which can be used to fund special projects.” In this regard, the issuer may issue bonds or other debt instruments that can be used as a means of financing the debt associated with the project. Debt financing has a clear start and end debt in mind. By purchasing the notes, the investor is offered some returns on top of the original amount. A good example of debt financing can be drawn from a corporation that underscores to sell bonds to fund a particular project. By virtue of selling bonds, the organisation will anticipate to gain some returns in the form of interests generated from the bonds. By selling bonds, an organisation will be better positioned to generate some revenue from the interests. Another example of debt financing is the use of direct debt instruments so as to fund the project. The debt will be paid in full after the completion of the project. In this regard, it will be expected that the project will be able to generate some revenue to repay back the debt. Debt financing will enable the organisation to acquire operating capital without disposing its assets or giving away its profits through selling shares. By virtue of selling bonds, the organisation will be able to sustain its present operations but the full debt will be paid in full after a given period. Such a method of financing debt will allow the company to be in control of their assets as well as profitability as they will ensure that they put measures that are meant to repay the bond in full after funding the project. As it stands, this method is concerned with borrowing money that can be repaid over a certain period of time where the lender is not entitled to get hold of the company’s profitability. On the other hand, equity financing mainly utilises the strategy of issuing shares of stock at a public offering (http://www.wisegeek.com/what-is-debt-financing.htm). Shares are sold to the members of the public and they continue to generate returns for the investors. For example, municipalities can offer shares to the public in order to fund a housing project over a certain period of time. In as long as the shares remain in place, the organisation will continue to get money through the shareholdings. As such, the organisation seeks to generate money without having to repay the debt over a certain period. The shares that are sold to the investors will generate revenue for the organisation that can be used to fund certain projects while the company will be in a position to maintain its assets. Returns for the investors will continue to be generated as long as the shares still exist. The main difference between debt and equity financing is that debt financing utilises the use of debt instruments to borrow money that can be used for a particular kind of project which will be repaid in full after a certain period of time. Bonds can be sold or the organisation can directly borrow money to fund special projects whereby the money will be repaid over a certain period. In contrast, equity financing entails that the organisation will exchange money for business ownership shares. In as far as equity funding is concerned, it can be noted that the organisation will get money without incurring debt or will not be obliged to repay the debt over a particular period. There is no debt involved in equity funding unlike in debt financing. Debt financing is more advantageous compared to equity financing given that the company will be obliged to pay back the debt over a certain period of time without risking losing the ownership of the organisation like in equity financing. The main disadvantage of equity financing is the apparent dilution of ownership interests of the company which may ultimately lead to loss of control of the company. In the long run, the profitability of the organisation may be affected as a result of the ownership structure which entails that the original owners of the organisation may not have full control of the company. It can be noted that debt and equity financing are two different methods that can be used to get money to finance certain projects. The main difference between the two is that debt financing utilises direct debt instruments to get money that will be repaid over a certain period of time. In contrast, equity funding is the generation of money through selling the shares of the company for certain returns. A close analysis of the two types of financing shows that debt financing has more advantages of equity financing since it does not affect the shareholding of the company. In the long run, a company that embarks of equity financing can risk losing control of the organisation since there will be many shareholders. References Schroeder, R.G., Clark, M.W., & Cathey, J.M. (2005). Financial Accounting Theory and Analysis, (8th Edition).  John Wiley & Sons, Inc. wiseGeek.com (2011). What is debt financing? Retrieved from http://www.wisegeek.com/what-is-debt-financing.htm Read More