Supporting Capitalization of all Leases - Essay Example

Arguments For and Against Capitalization of all Leases By: Arguments For and Against Capitalization of all Leases Currently, there are two kinds of leases: capital lease and operating lease. There is a current proposal of the International Accounting Standards Board to capitalize both finance and operating leases based on the Statements of Financial Position or Balance Sheets proposal. The widespread debate between academics, regulators, the profession and users is very understandable. The Framework for the Preparation and Presentation of Financial Statements offers persuasive arguments to change to the capitalization of all leases. The current status shows that the world is divided in terms of accepting the proposal to transform to the capitalization of all leases. International Accounting Standards no. 17 states that a lease may qualify either as a capital lease or operating lease (http://www.ifrsclass.com/gaap/ias/ias-17.htm). Under capital lease, all the risks and rewards are transferred to the lessee. To resolve the differences between the two international accounting standards, both accounting boards agreed to meet to come up with a common stand on capital lease accounting scheduled in 2011. (Kirk 2005; 85). The proposal to capitalize all leases should not be implemented. The proposal to implement the capitalization of all leases should not be implemented. Capitalization entails ownership. Capitalization means that the company has to depreciation the assets. Thus, it would be illogical to implement the proposal to capitalize all leases. The new proposal states that operating leases should be capitalized. Under the current accounting environment, there are minimum guidelines to be followed before a lease is capitalized. A lease that does not qualify as capital lease is recorded as an operating lease. This is illogical because the lessee is just renting (borrowing) the premises and is not buying. Under the capital lease, the lessee can include the capital lease asset as part of one’s total assets. This will create a better financial picture of the company when compared to not having the leased property capitalized. Second, the company can use the capitalized assets as collateral for the processing of the company’s new long term loans. The banks will scrutinize the financial statements to determine if there are enough assets to cover for possible nonpayment of loans or other payables (Elliot & Elliot). This would be illogical because the company does not own the building or facilities rented. Further, the lessee becomes the owner of the property after fulfilling the requirements set forth under International Accounting Standard no. 17. However, there are some differences between the U.S. FASB Financial Accounting Standard no. 13, Accounting for Leases and International Accounting Standards no. 17 that need to be revised. The International Accounting Standards does not implement the U.S. GAAP capital lease criteria. The criteria for determining whether the asset acquisition is an operating lease contract includes 75 percent or more economic life policy and the 90 percent or more fair market value. The International Accounting Standards uses the criteria facts and circumstances to determine if the lease should be classified as a capital lease or operating lease (Wanjalin 2004; 69). This would also be illogical because the company does not own the building or facilities rented. Likewise, the company will be engaging in a sale contract. The contract may focus is the sale of a building, land, equipment, or other high value assets. Another advantage is the possibility of paying the capital lease assets on installment basis. There are different ways of purchasing an asset. First, the company can choose to pay the entire amount in full. Second, the company can choose to pay the amount equally for several months or years. Meanwhile, the company can proudly show off the newly bought factory equipment, office equipment, or delivery equipment. During the entire payment period, the lessee can present the leased asset as part of the company’s newly acquired buildings, factory equipment, delivery equipment and other asset types (Wanjalin 2004; 69). Again, this would be illogical because the company does not own the building or facilities rented. There are many disadvantages in the implementation of the capitalization of all leases. First, there are disadvantage in the capitalization of leases. First, the company may not generate enough profits to recover the cost of investing in a capital lease. The investment may come in the form of a new building across the street from a fast food chain, a restaurant, or school premises. The new owner of the capital lease asset may not be able to recover the amount paid for buying, repairing, and renovating, and beautifying the newly bought building, plant, or other assets during the lifetime of the capital lease(Stickney 2009; 882). In addition, the company will have to honor its commitment to pay the remaining monthly balances in compliance with a capital lease contract for fear of being sued in court for breach of contract. This is not a good scenario especially when the company continues to generate losses from the sale of the company’s products and services. Basing an investment decision on the feasibility studies may not come out as projected. The current economic depression enveloping the United States and some parts of Europe caused many companies to file for bankruptcy (Stickney 2009; 882). Likewise, the company will suffer the corresponding risks that are characteristic of any capital lease agreement. The building may be lost through fires, floods, hurricanes, and other unexpected calamities. In terms of calamity examples, a fire may breaks out and the building is not insured against fire loss. Likewise, an unexpected 9.8 Richter scale earthquake may level a 30 -story building to the ground. This translates to thousands of capital lease investments going down the drain. Aside but the building loss, harsh acts of nature, calamities, may cause the lives of people trapped within the building premises (Stickney 2009; 882). Further, the company needs lots of idle cash to pay for the startup costs of the capital lease investment. Startup costs include repairing a newly bought dilapidated building. Startup costs include payment for other building construction expenses like labor, wood, cement, nails, and the professional fees of the architect and building engineer. One such construction cost is the construction of a pavement so people can easily travel to the company’s store area from their place of residence or work (Stickney 2009; 882). Furthermore, it may be hard to find a building owner who is willing to sell one’s property. The building owner may be interested in renting the building on an operating lease concept. The landlord may persuade the client to accept an operating lease agreement. The company owner may not be in the mood to sell the building because it is strategically located. In this case, the lessee may have to accept the operating lease agreement so the tenant can immediately start selling its products and service to the company’s current and prospective clients (Alexander & Jorrisen). Under the present accounting setup, there are many advantages of continuing the operating lease concept. A lease that does not qualify as capital lease will automatically be classified as operating lease. Under the operating lease concept, the lessee will record the regular lease payments for the use of the building, equipment, and other resources rented as expense accounts because the company does not own the building or facilities rented. The expense account, Rent Expense, is another account that will help reduce the company’s profits. In turn, the company will be able to reduce its taxes. The taxes are computed based on the company’s net profits. An increase in expenses, that includes rent expense, reduces net income. A reduction in net income will also reduce the amount of income tax payable to the London government. The company will not increase its assets because the company is simply renting the asset. Under the operating lease agreement, the lessee knows that the owner of the company can easily retrieve their property and continue the business strategy of the company after the operating lease contract expires (Rutherford 2007; 195). Further, the operating lease lessee can easily transfer from one building, lot, community, or city as part of the company’s strategic plan to increase its revenues because the company does not own the building, equipment, or facilities rented. For example, the company would be willing to transfer its store to another city because the new location is more populated than the present one. The move is seen as a good marketing strategy. The marketing strategy of transferring to another location is a very excellent marketing strategy. It can even be the most logical way to generate more revenues and profits. The company can inform the landlord that the company will be closing shop at the end of the month. Next, the company can scout for another strategic store location in the next city to increase the sales of the company’s products and services. The company does not have to worry about the building’s physical condition after the building is returned to the owner (Rutherford 2007; 195). Furthermore, the lessee in the operating lease engagement does not have to worry about fire loss in terms of the building structure. The operating lease tenant can easily transfer to another building if the current office is gutted down by a fire. Further, the company does not have to worry about the repairing and maintaining the building. The tenant does not have to renovate the building because the owner will take back the building or premises after the expiration of the lease term. The company will save on costs of painting the building on a regular basis. The building or facilities owner has to do the repair and maintenance for it is the property of the landlord. In addition, the operating lease lessee does not need to shell out lots of cash to improve the building’s current facade. Usually, the capital lease client will need lots of money to pay the initial cash to pay for the use of the capital lease facilities. Under the capital lease, the client has to pay the land, building, or facilities. The capital lease tenant has to input a huge initial outlay as a sign that the capital lease client is serious in offering to buy the property under the capital lease agreement (Rutherford 2007;195). Last, the continued implementation of the operating lease preference is a good choice for people who are experimenting with a new business idea. The company will be able stop payments on the building rent after determining that the past months’ net loss financial statement picture indicates that there is no hope of recuperating the expenses of renting the building. A bleak picture of the company’s financial picture occurs when there is no material sign that indicates a financial miracle. For example, a company that is generating net loss for the past eight months would find the idea of closing the store a brilliant alternative to continuing the store’s present course where the company’s assets are siphoned off (Rutherford 2007;195). Personally, it is preferable prevent the implementation of the proposal to capitalize all leases, including operating leases. Under the alternative to capitalize all finance leases, the new owner of the building can go with the heart’s desire in terms of maximizing the renovation of the building premises because the client is the capital lease owner of the building premises. Under the operating lease, the lessee is hindered by the thought that investing lots of money to beautify the building would soon come to nothing. The building owner may ask the tenant to vacate the premises when the lease agreement ends. The operating lease client can just stand by and see the building owner set up one’s own store as a replacement for the tenant’s grocery outlet when the lease period comes to a halt. The capital lease (financing) agreement is the preferable choice especially when the tenant has lots of idle cash. The idle cash can be used to buy the new building, factory, equipment, and other high value assets. Immediately, the company can implement repair and maintenance operations to make the store ready for client visits within the earliest possible time. BRIEFLY, the world is divided in terms of capitalizing all leases. There is a current proposal of the International Accounting Standards Board to capitalize both finance and operating leases on the Statements of Financial Position or Balance Sheets of lessees. There is a widespread debate among different interested parties in terms of the proposal to capitalize losses International Accounting Standards no. 17 states that a lease may qualify either as a capital lease or operating lease .Under capital lease, all the risks and rewards are transferred to the lessee. To resolve the differences between the two international accounting standards, both accounting boards agreed to meet to come up with a common stand on capital lease accounting scheduled in 2011. Indeed, the proposal to capitalize all leases must not be implemented. REFERENCES Kirk, R. U.K. Accounting Standards. London: Elsevier Press, 2005. IAS 17, retrieved November 5, 2010. Rutherford, B. Financial Reporting in the U.K. London: Taylor & Francis Press, 2007. Stickney, C. Financial Accounting . London: Cengage Learning, 2009. Wanjalin, G. An Intenational Dictionary of Accounting and Taxation. London: I Universe Press, 2004. Elliot B & Elliot S, FINANCIAL ACCOUNTING & REPORTING) 6th Edition Alexander, B., & Jorrisen, INTERNATIONAL FINANCIAL REPORTING & ANALYSIS Read More