Accounting Treatment of Leased Assets - Essay Example

REPORT ON ACCOUNTING TREATMENT OF LEASED ASSETS Introduction This report sets out the basic rules for the treatment of leased assets for the lessee. It represents the financial characteristics of leasing transactions and proves its best accounting treatment. We had been following the treatment of entering assets in our balance sheet, but recently it was commented that it should be treated as liabilities in our balance sheet as we do not owe those assets for several years. Leased assets’ accounting treatment has been subjected for many discussions by accounting specialists and hence there are different views among them. Even though, leased assets are not legally owned by lessee, he has the right over the leased assets to make use of and earn profits out of it and hence it should come under the asset side of the balance sheet. Understanding characteristics of leased assets and its accounting standards would be helpful to identify the best method of treating leased assets. Leasing Transactions Leasing is an agreement between two parties, namely lessor and lessee, for the hire of an asset. By the agreement, the lessor provides the lessee with the right to use and make profits for the agreed period and the lessee pays a lease rental to the lessor in return for the use of asset. The lessor is regarded to be the legal owner of the asset who rents out the asset to the lessee. Normally, at the end of the leasing period the asset is given back to the lessor. Being the owner of the leased property, the lessor in real meanings allows the lessee quiet enjoyments only if the lessee continues to fulfill the obligations. This simple accounting behavior itself outlines the best method of treating leased assets in the balance sheet. On the event of a default, the lessor has a right to repossess the property and a duty to remarket the leased property. For accounting treatment purposes, leases are classified in to two, ‘finance lease’ and ‘operating lease’. An operating lease is a very short term agreement for the temporary hiring of a particular asset. A finance lease is a long term agreement that represents a loan made by the lessor to the lessee to buy the asset. In this lease, risks and rewards of the ownership of an asset will be substantially transferred to the lessee. It is considered to be a rental agreement and legally the lessee has not bought the asset because the title remains with the lessor. However, it is highly important that the commercial reality of events and accounting transactions need to be reported in the financial statement. Basic Accounting Treatment Simon Benninga emphasizes that accounting experts have found leases troublesome. Before the advent of Financial Accounting Standards Board Statement in 1976, it was common for firms to leave leases off their balance sheets altogether, and to record the fact that some assets were leased only in footnotes to the financial statement” (Simon Benninga and Benjamin Czaczkes, p. 112). In the case of finance lease, the present value of an asset and its associated liabilities is treated as a debt and the interests on this amount will be recorded on the statement. The leased asset itself is will be depreciated over a certain period of time and same time the liabilities are amortized as the lease is being paid. At the starting up of the business, lease should be distinguished as an asset and a liability at lower of the fair value of the leased asset and the present value of minimum lease payments. Lease payments should be appropriated between finance charge and the fall in outstanding liability in order to make out regular interest rates on the liability balance. The depreciation on the leased assets will treated same as the depreciation of other assets. Assets acquired under finance lease, net amount and total minimum lease payments at the date of the balance sheet, and their present values must be disclosed. The lessee needs to record assets in its own accounts because when a lessee enters in to a finance lease, it is getting access in to the risks and rewards of the assets. In accounting, an asset means rights or other access to the future economic benefits controlled by an entity as a result of past transactions or events. According to Svetozar Pejovich, asset means property rights in that particular asset (Svetozar Pejovich, Inc NetLibrary, p. 21). From this definition it is very clear that a leased asset can bring rewards and make profits and hence it is by accounting definition and standards mere assets to be recorded as assets in the balance sheet. Same time, when a lessee enters in to a finance lease it is obliged to make the lease rental payments for the fixed period of lease and hence the lessee must consider it to be liability, because, the term liability means an obligation to transfer economic benefits as a result of past transactions or other events. According to the accounting standards, the lessee needs to capitalize the present value of the minimum lease payments as the fixed asset and this is the liability amount to be recorded. The present value of the minimum payment for the leased asset would be equal to the cash price. The asset will be depreciated over the short period of the lease. In the balance sheet, the finance lease obligations need to be split between current and long term creditors. Assets legally owned and those not legally owned by the lessee must be included in the listings in the fixed assets schedule in balance sheet. Off-balance sheet financing It was commented in the last meeting that we shouldn’t damage out interests and mislead everybody by showing a gearing ratio that is considerably worse than it really is. So, this is worthwhile to mention about gearing ratio and off-balance sheet financing. Gearing ratio simply means a financial ratio that compares some form of owner’s equity to borrowed funds. The higher a company’s degree of leverage, the more the company is considered risky. There are companies that show less leverage deliberately so as to mislead the public and investors. Off-balance sheet financing allows a company to borrow more being without affecting calculations of measures of indebtedness. The main motive behind this off-balance sheet financing is that it can mislead investors. But, it has been viewed that scope for off balance sheet financing has reduced over the years as accounting standards have caught up with loopholes that allowed off-balance sheet financing. Rick Watson and Jeremy Carter emphasize that off-balance sheet financing would be satisfactory if securitization needs to be undertaken. Whether or not this is important depends on the reason for a particular entity undertaking a securitization. If the securitization is being undertaken for funding reasons, then off balance sheet treatment may, at most, be a ‘nice to have’ rather than critical. Often, financial institutions seeking regulatory capital relief will need off-balance sheet treatment to satisfy the regulators’ rule. (Rick Watson and Jeremy Carter, p. 79). Currently, off-balance sheet financing does not seem to be much of a problem and hence it is clear that the current method of treating leased asset in our balance sheet neither damages out interests nor misleads the public by showing a gearing ratio. Conclusion This report is an attempt to show the exact accounting treatment of leased asset and to outline the features of lease accounts. The comment made by newly appointed director brought us to think widely about best accounting practice and accounting standard of treating leased asset. References RICK WATSON AND JEREMY CARTER (2006), Asset Securitisation and Synthetic Structures: Innovations in the European Credit Markets, Euromoney Books SIMON BENNINGA & BENJAMIN CZACZKES, (2000), Financial Modeling, MIT Press, ISBN 0262024829 SVETOZAR PEJOVICH & INC NETLIBRARY (1990), The Economics of Property Rights: Towards a Theory of Comparative Systems, by Springer Read More