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In order to inform you of the upcoming changes in lease accounting and the impact on IFRS reporting for fleets, LeasePlan’s Head of Consultancy Matthew Walters answers the most important questions on this topic in the below Q&A.
For years, lease accounting has been criticized as a means of structuring off-balance sheet financing, particularly as it related to the airline industry. In response to this feedback, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) initiated a joint project to overhaul accounting for leases in 2008, which was one of the cornerstone projects of a path towards convergence.
The FASB issued an exposure draft in 2010, but it received such heavy criticism from multiple parties that it didn't issue the final standard until early 2016. Accounting Standards Update 2016-02, Leases (ASC Topic 842) may be cumbersome to implement as it affects all leases (i.e. property, equipment, copiers) with only a few, minor scope exceptions. It also removes any differences between leases of equipment and real estate that exist in today's U.S. generally accepted accounting principles (GAAP).
The New Lease Accounting Standard And You Whitepaperjtagliente
If you are not aware of the impact that the new FASB 13 rules being introduced this year will have on your company then you must read this. It is startling!
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Accounting and Financial Reporting – Current Developments .docxnettletondevon
Accounting and Financial Reporting – Current Developments
156
I. Changes Coming To Lease Accounting
The FASB's lease accounting project has nine lives and has survived two exposure drafts while
headed toward final passage. As of early 2015, the FASB is putting the finishing touches on a
new lease standard that, when passed, will make dramatic changes to the way companies
account for lease transactions. In particular, most leases will be capitalized, resulting in billions
of dollars of assets and liabilities being recorded on company balance sheets.
Although the lease accounting project has gone through numerous changes, the fundamental
concept that leases be capitalized is not going to change in the final document.
In this section, the author discusses the general concepts that are included in the most recent
lease exposure draft, with modifications that have been proposed by the FASB through their
ongoing deliberations.
Background
Under current GAAP, ASC 840, Leases (formerly FASB No. 13), divides leases into two
categories: operating and capital leases. Capital leases are capitalized while operating leases
are not. In order for a lease to qualify as a capital lease, one of four criteria must be met:
1. The present value of the minimum lease payments must equal or exceed 90% or more of
the fair value of the asset.
2. The lease term must be at least 75% of the remaining useful life of the leased asset.
3. There is a bargain purchase at the end of the lease.
4. There is a transfer of ownership.
In practice, it is common for lessees to structure leases to ensure they do not qualify as capital
leases, thereby removing both the leased asset and obligation from the lessee’s balance sheet.
This approach is typically used by restaurants, retailers, and other multiple-store facilities.
Consider the following example:
Facts:
Lease 1: The present value of minimum lease payments is 89% and the lease term is 74% of
the remaining useful life of the asset.
Lease 2: The present value of minimum lease payments is 90% or the lease term is 75% of the
remaining useful life of the asset.
Accounting and Financial Reporting – Current Developments
157
Conclusion: There is a one percent difference between Lease 1 and Lease 2. Lease 1 is an
operating lease not capitalized, while Lease 2 is a capital lease under which both the asset and
lease obligation are capitalized.
SEC pushes toward changes in lease accounting
In its report entitled Report and Recommendations Pursuant to Section 401(c.) of the
Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special
Purpose Entities, and Transparency of Filings by Issuer, the SEC targeted lease accounting as
one of the areas that results in significant liabilities being off-balance sheet.
According to the SEC Report that focused on U.S. public companies and a U.S. Chamber of
Commerce report:
a. 63 .
An analyst has decided to capitalize the operating leases of Company.pdffazanmobiles
An analyst has decided to capitalize the operating leases of Company A. Using information in
the notes to the company’s 2015 financial statements, she has determined that the present value
of future minimum lease payments, at a discount rate of 10 percent, on December 31, 2015
equals €500 million. All lease contracts last another 5 years on December 31, 2015. As expected
at the beginning of the year, the company reports an operating lease expense in its income
statement for 2016 of €80 million. The company’s tax rate equals 30 percent. The company does
not engage in any new operating leases in 2016. The following information is also available from
Company A’s financial statements (all ratios use beginning-of-the-year balance sheet values)
Debt to capital (at beginning of 2016) = 0.55
Return on beginning equity in 2016 = 0.10
Assets / Capital (at beginning of 2016) = €3,400 million
The effect of capitalizing Company A’s operating leases on its return on beginning equity equals
A. An increase from 0.10 to 0.15 (rounded).
B. An increase from 0.10 to 0.13 (rounded).
C. A decrease from 0.10 to 0.07 (rounded).
D. A decrease from 0.10 to 0.05 (rounded).
Solution
accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees
in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS
17, Leases takes the concept of substance over form and applies it to the specific accounting area
of leases.
When applying this concept, it is often deemed necessary to account for the substance of a
transaction – ie its commercial reality, rather than its strict legal form. In other words, the legal
basis of a transaction can be used to hide the true nature of a transaction. It is argued that by
applying substance, the financial statements become more reliable and ensure that the lease is
faithfully represented.
WHY DO WE NEED TO APPLY SUBSTANCE TO A LEASE?
A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the
legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments.
Historically, assets that were used but not owned were not shown on the statement of financial
position and therefore any associated liability was also left out of the statement – this was known
as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities
low, thus distorting gearing and other key financial ratios. This form of accounting did not
faithfully represent the transaction. In reality a company often effectively ‘owned’ these assets
and ‘owed a liability’.
Under modern day accounting the IASB framework states that an asset is ‘a resource controlled
by an entity as a result of past events and from which future economic benefits are expected to
flow to the entity’ and a liability is ‘a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow fr.
Lease accounting received an accounting overhaul with the recent release of the Financial Accounting Standards Board (FASB)'s Accounting Standards Update 2016-02 Leases (Topic 842). The new standard most significantly changes lessee accounting compared to existing US GAAP, but also has some targeted changes for lessor accounting. Overall, ASU 2016-02 seeks to improve transparency to the economics of lease transactions and bring lease accounting into line with other recently released accounting standards updates, such as the changes to Revenue from Contracts with Customers (Topic 606).
416Business firms generally acquire property rights in lon.docxgilbertkpeters11344
416
Business firms generally acquire property rights in long-term assets through
purchases that are funded by internal sources or by externally borrowed
funds. The accounting issues associated with the purchase of long-term
assets were discussed in Chapter 9. Leasing is an alternative means of
acquiring long-term assets to be used by business firms. Leases that are not
in-substance purchases provide for the right to use property by lessees, in
contrast to purchases that transfer property rights to the user of the long-
term asset. Lease terms generally obligate lessees to make a series of pay-
ments over a future period. As such, they are similar to long-term debt.
However, if a lease is structured in a certain way, it enables the lessee to
engage in off–balance sheet financing (discussed in Chapter 11) because cer-
tain leases are not recorded as long-term debt on the balance sheet. Busi-
ness managers frequently wish to use off–balance sheet financing in order
to improve the financial position of their companies. However, as noted
earlier in the text, efficient market research indicates that off–balance sheet
financing techniques are incorporated into user decision models in deter-
mining the value of a company.
Leasing has become a popular method of acquiring property because it
has the following advantages.
1. It offers 100 percent financing.
2. It offers protection against obsolescence.
3. It is frequently less costly than other forms of financing the cost of the
acquisition of fixed assets.
4. If the lease qualifies as an operating lease, it does not add debt to the
balance sheet.
CHAPTER
13
Leases
Introduction 417
Many long-term leases possess most of the attributes of long-term debt.
That is, they create an obligation for payment under an agreement that is
noncancelable. The adverse effects of debt are also present in leases in that
an inability to pay may result in insolvency. Consequently, even though
there are statutory limitations on lease obligations in bankruptcy proceed-
ings, these limits do not affect the probability of the adverse effects of non-
payment on asset values and credit standing in the event of nonpayment of
lease obligations. The statutory limitations involve only the evaluation of the
amount owed after insolvency proceedings have commenced.
Management’s choice between purchasing and leasing is a function of
strategic investment and capital structure objectives, the comparative costs of
purchases of assets versus leasing assets, the availability of tax benefits, and per-
ceived financial reporting advantages. The tax benefit advantage is a major fac-
tor in leasing decisions. From a macroeconomic standpoint, the tax benefits of
owning assets may be maximized by transferring them to the party in the higher
marginal tax bracket. Firms with lower effective tax rates may engage in more
leasing transactions than firms in higher tax brackets since the tax benefits are
passed on to the lessor. El-Gazzar et .
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I. IntroductionSince the Enron sandal in 2001, Security Exchange C.docxsheronlewthwaite
I. Introduction
Since the Enron sandal in 2001, Security Exchange Commission (SEC has made closing loopholes it’s hope priority. The SEC realized that there was a loophole relating to leasing. In 2006, FASB began to work on a new lease accounting standard intended to close the loophole of off-balance operating leases. The FASB and IASB issued a Discussion Paper proposing that lessees capitalize all leases on the balance sheet was done in 2009. In 2010, the FASB and IASB issued an Exposure Draft and distribute it for public comments. The model set forth in the ED proposed that lessees move all leases onto the balance sheet as a right-of-use asset and liability.
By 2013, the FASB and IASB issued a Revised Exposure Draft and opened a four-month comment period. After, the boards solidified parts of the standard, including that all leases would be brought onto the balance sheet, expense recognition models, and liability measurement. In 2016, the FASB published ASC-842, the new lease accounting standard for companies reporting under US GAAP. The IASB issued IFRS 16 the new lease accounting standard for companies reporting under the International Financial Reporting Standards.
In 2018, the FASB issued an update to ASC 842 to both clarify and simplify the application of the new lease standard to land easements. The FASB also issued a proposal to ease companies’ transition to the new standard by offering a practical expedient that would allow companies to apply the transition provisions at the adoption date, instead of at the earliest comparative period. The proposal was approved in July of 2018.Objective of Research Project.
The objective of the Research Project is to describe some of the key differences of presenting and reporting Leasing in the Financial Statements under U.S. GAAP and IFRS. Organization of text.
This paper starts by presenting the guidance applicable to Inventory under US GAAP and IFRS, this section contains the specific reference in each case as well as an illustrative case, who serves as an example of the application of the referred guidance. This section is followed by a little of history. A summary of History of Convergence by each standard as well a history of convergence between them. After having a theoretical picture of the Accounting Standards that rule Inventory, I compare both, beginning with its similarities and then explaining each of the differences encountered. Finally, I talked about the expectation of greater convergence between IFRS and US GAAP, exposing its possible impact and the elements that impede the complete convergence between them. At the end, the conclusions of this paper.U.S. GAAP Accounting Standards for Presentation of Financial Statements.Standard
The primary US GAAP and SEC guidance applicable to leasing accounting is the ASC 842 Leasing.Illustrative Case.
A lessee shall either present in the statement of financial position or disclose in the notes all of the following:
a. Finance lease right-of-u ...
Accruals are non-cash items of income and represent adjustments made for cash flows that do not create a benchmark for profits that are generally influenced by matuarity and cash payments, and increase expected returns of profitability and reduction of offsetting liabilities. The results indicate that operating profitability is based on liquidity of profitability factor, and, moreover, adjusted operating profit based on operating cash flow is predicted at current yield stage. An investor can increase a Sharp strategic ratio by adding an adjusted operating profit factor to a larger investment position.
McKonly & Asbury’s April webinar entitled, “Leasing: A New Standard is Finally Here” is hosted by Dan Sturm, Partner; Brett Bauer, Senior Manager; and Tim Showers, Supervisor. During this webinar, attendees will learn how ASC 842 differs from ASC 840; will see illustrative financial statements which highlight exactly what changes as a result of the new standard; and will gain an understanding of what they should be doing now to prepare.
Similar to Martin-Jiang Internal Auditing 0514 (20)
1. A
lease is a contractual agree-
ment in which the owner,
or lessor, of an asset, such
as real estate or equipment,
grants the right of usage to
a lessee for a specified amount of time. In
return for the usage right, the lessee pays
the lessor rent over a specified period of
time, known as the term.
Current guidelines for accounting
treatment of leases declare a lease as
either a capital or operating lease. The
Financial Accounting Standard No. 13
(FAS 13) states,“[A] lease that transfers
substantially all of the benefits and risks
incident to the ownership of property
should be accounted for as the acquisi-
tion of an asset and the incurrence of
an obligation by the lessee and as a sale
or financing by the lessor.”1
Companies
follow a set of “bright-line” rules for
classifying leases as either capital leases,
which are reported on the balance sheet
as an asset along with its corresponding
liability, or operating leases, which are
considered “off balance sheet arrange-
ments” for which the corresponding val-
ues are instead disclosed in financial
statement notes.2
Rules-based lease accounting has made
it possible for parties to structure leas-
ing transactions to achieve desired
accounting outcomes.3
These rules-based
criteria have allowed companies to cir-
1MAY/JUNE 2014 INTERNAL AUDITING
EVALUATIONOF
THEIMPACTOF
PROPOSEDCHANGES
TOLEASING
ACCOUNTING
STANDARDSJOH N H . MA RTIN A N D W EI J IA N G
JOHN H. MARTIN ha s over 25 yea rs of working experience from interna tiona l sa les, ma rketing, a nd business ma n-
a gement. He is currently the opera tions ma na ger for Coa stline Equity, Inc., a rea l esta te ma na gement services firm
in Torra nce, CA. He ca n be rea ched a t johnhmar tin@y mail.com.
WEI JIANG is a n a ssocia te professor of a ccounting a t Ca lifornia Sta te University, Fullerton. His prima r y resea rch
interests include fina ncia l reporting qua lity, interna l control, corpora te governa nce, a nd executive compensa tion.
His resea rch findings have been published in Contemporar y Accounting Research, Journal of Banking and Finance,
Advances in Accounting, International Journal of Auditing, Research in Accounting Regulation, a nd a number
of other journa ls. He ca n be rea ched a t wjiang@fuller ton.edu.
..........................................................................
This article examines the impact of proposed lease accounting changes on
assets, liabilities, income, and return on assets for U.S. retailers and airlines.
2. .......................................................................................
cumvent the spirit of the capital lease
designation guidelines. A large majority
of long-term corporate leases are clas-
sified as operating leases, likely due to
the gaming of rules for structuring leases
in order to obtain the operating lease
designation.4
The existing lease account-
ing rules have been criticized for failing
to meet the needs of users of financial
statements because they do not always
provide a faithful representation of leas-
ing transactions.
In fact, the Securities and Exchange
Commission (SEC) identified the need
for changes in lease reporting in its 2005
report to Congress as required by the
Sarbanes–Oxley Act of 2002. It deter-
mined that, among SEC registrants, off
balance sheet lease obligations totaled 31
times the amount of on balance sheet
obligations.5
A portion of these off bal-
ance sheet arrangements were operat-
ing leases.
The Financial Accounting Standards
Board (FASB) and the International Secu-
rity Advisory Board (ISAB) commenced
the joint project in 2006. In 2010, the
FASB released the exposure draft “Pro-
posed Accounting Standards Update:
Leases (Topic 840),” which relates to FAS
13 issued in 1976 and provides guidance
for lessees and lessors in recognizing,
measuring, and presenting assets and
liabilities from leases.6
As a follow-up,
on May 16, 2013, the FASB also released
“Proposed Accounting Standards Update:
Leases (Topic 842).”7
The FASB and the
ISAB plan to consider interested par-
ties’ feedback and begin re-deliberations
of all significant issues in the first quar-
ter of 2014 to finalize the rules. Imple-
mentation of these approved changes
will most likely not be required before
2016.
The stated objective of the FASB is to
“establish principles that lessees and
lessors shall apply to report relevant and
representationally faithful information
to users of financial statements about
the amounts, timing and uncertainty of
the cash flows arising from leases.” The
FASB exposure draft defines a lease as “a
contract in which the rights to use a
specified asset or assets is conveyed, for
a period of time, in exchange for con-
sideration.”8
The exposure draft pro-
poses that lessees and lessors should
apply a right-of-use model in account-
ing for most leases and that lessees and
lessors should present the assets, liabil-
2 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION
EXHIBIT 1 Financial Statement Data
3. ities, income, expenses, and cash flows
arising from leases separately from other
assets, liabilities, income, expenses, and
cash flows.9
Lessees most affected by the proposed
changes would be those with a majority
of their property leases classified as long-
term operating leases, which is a com-
mon practice in the retail and airline
industries. The requirement that nearly
all leases be treated as capital leases
would likely result in a material change
in balance sheet account valuations and
in key measures of financial performance.
In this study, we empirically examine
the impact of the proposed lease account-
ing changes on assets, liabilities, income,
and return on assets (ROA) for the 10
largest retailers and five largest airlines
in the United States. For illustration pur-
poses, we focus on changes in the first
year following conversion. While lease
capitalization will increase asset and lia-
bility reporting on balance sheets, we
expect net income and ROA to be neg-
atively affected by the conversion. While
the direction of the change is easy to
predict, the degree of change is unknown.
The purpose of this study is to provide
an assessment of the magnitude of the
potential changes as well as to deter-
mine which companies in a particular
industry will be most affected by the
changes when compared to their peers.
Exhibit 1 presents the basic financial
statement data required for conversion.
All data are collected from firms’ 10-K
reports for fiscal year 2012. Reclassifying
operating leases as capital leases requires
making assumptions about time remain-
ing on individual leases, the actual inter-
est rate used in the lease agreement with
the lessor, and the effective interest rate
used by the company in its debt obliga-
tions, which are not readily available from
financial statements. The assumptions
and research methodologies used in this
article follow prior accounting literature,
textbooks, and practice.10
An examination of the company data
shows that both industries make extensive
use of operating leases, with 88 percent
and 89 percent of the total leases being com-
prised of operating leases for retailers and
airlines, respectively. The airline indus-
try, however, is less profitable and generates
lower revenue than the retail industry
($36.8 million versus $101.6 million).
Intense competition among airline com-
panies in recent years has driven up cap-
ital and operating costs and cut into profits.
By similar reasoning, airline companies
are generally assigned lower debt ratings
by Moody’s.11
3LEASE CAPITALIZATION MAY/JUNE 2014 INTERNAL AUDITING
............................................................................................
EXHIBIT 2 Balance Sheet Adjustments
4. Balance sheet adjustments
Panel A of Exhibit 2 presents the changes
in assets and liabilities after converting
existing operating lease obligations into
capital lease accounting treatment for
companies in the retail industr y. As
expected, all companies experience a
significant increase in both assets and lia-
bilities. The range of increase for assets
is a low of 6.31 percent for Target and a
high of 95.29 percent for Walgreens with
an average industry increase of 26.37
percent. The increases in liabilities are
even higher, ranging from 9.25 percent
for Target to 191 percent for Walgreens
with an average industr y increase of
46.90 percent. Note that there is a direct
relationship between the percentage of
current operating leases and the changes
in assets and liabilities: the lower the
number of operating leases required to
be converted, the smaller the change in
the asset/liability valuation. Of the 10 retail-
ers in our sample, Target has the small-
est number of operating leases in need
of conversion at 47 percent, while Wal-
greens has 99 percent of its lease oblig-
ations currently classified as operating
leases. This explains why Walgreens
exhibits a significantly higher increase
in both assets and liabilities than Target.
The results for the airline industry are
displayed in Panel B of Exhibit 2. The air-
line industry averages an increase of
30.83 percent in assets and 31.45 percent
in liabilities. The range of increase for
assets was a low of 21.02 percent for
Southwest and a high of 42.6 percent for
US Airways. Despite its fleet size being
the third largest, Southwest has the low-
est future operating lease obligations
among all airlines (see Exhibit 1) and
therefore would be the least affected by
lease capitalization. In comparison,
although the dollar amount of future
lease obligations for US Airways is sec-
ond to last behind Southwest, it also has
the smallest declared asset valuation
amount prior to conversion. The abnor-
mally low asset basis raises the likeli-
hood that a relatively small absolute
increase in asset value would produce a
disproportionately large percentage
increase. As for the changes in liabilities,
US Airways continues to rank the high-
est with an increase of 43.88 percent.
Delta, on the other hand, replaces South-
west to post the smallest increase in lia-
bilities at 21.09 percent. This is principally
due to the fact that Delta’s liabilities
prior to the conversion are extremely
high, hence mitigating the effect of any
4 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION
..........................................................................................
EXHIBIT 3 Income Statement and Return on Assets Adjustments
5. .......................................................................................................................................................
increase in liabilities on a percentage
change basis.
Income statement adjustments
We next examine the effect of lease cap-
italization on income. The results are
reported in Exhibit 3. Consistent with our
expectations, all sample firms experi-
ence a reduction in income with an aver-
age decline of 24.34 percent and 55.75
percent for retailers and airlines, respec-
tively. The average reduction is greater
than the prediction put forth by the
Equipment Leasing and Finance Foun-
dation study, which projects a 2.4 per-
cent decrease in pre-tax net income.12
This is primarily due to retail and air-
line sectors having a greater proportion
of operating leases than other indus-
tries, as shown in Exhibit 1.
Within the retail group, Target’s income
decreases the least by just 2.25 percent.
At 47 percent, Target has by far the low-
est amount of current lease obligations
classified as operating leases. A general
rule is that the lower the number of oper-
ating leases in need of conversion, the
smaller the negative effect on reported
income. Best Buy, on the other hand,
takes the greatest loss in income with a
decrease of 64.88 percent. While the per-
centage of operating lease obligations
for Best Buy is below the industry aver-
age at 87 percent, two additional factors
contribute to the large income reduc-
tion. Best Buy has the highest imputed
interest rate and shortest lease term
among all retailers in this study. Higher
discount rates and shorter periods
remaining on lease obligations gener-
ally translate into greater income reduc-
tion when operating leases are converted
into capital leases. The short time remain-
ing on Best Buy’s estimated lease term
is likely intentional due to its declining
revenues and uncertain future. In other
words, they will not be opening new
stores or intending to renew options on
existing leases that will soon expire due
to the uncertainty of its current busi-
ness model as a big box retailer in the con-
sumer electronics sector.
Turning to the airline sector, it appears
that the effect of lease capitalization on
income is more volatile. Its reduction
in operation income ranges from a low
of 19.10 percent for American Airlines
to a high of 108.58 percent for United
Continental with an average drop of 55
percent. In comparison to the retail in-
dustry, the airline industry has rela-
tively larger operating lease commit-
ments and lower revenues (see Exhibit 1),
hence resulting in a far greater percen-
tage change in income after converting
operating leases to capital leases. In
addition, the airline industry on aver-
age carries a lower debt rating as assigned
by Moody’s due to greater earnings fluc-
tuations (see Exhibit 1). A lower debt rat-
ing translates into higher imputed interest
expense under capital and lower income,
and everything else is equal. All of these
factors contribute to the greater income
loss for the airline industry as a result
of lease capitalization.
ROA adjustments
A key financial ratio often cited by ana-
lysts in assessing a company’s profitability
is the return on assets (ROA). Compa-
nies are expected to experience a reduc-
tion in their ROAs due to increasing asset
valuation and decreasing income for all
companies. The results reported in
Exhibit 3 support this conjecture. Within
the retailer group, the lowest loss in ROA
is Target at 0.52 percent, with a decline
from 6.48 percent to 5.96 percent. The
greatest reduction is experienced by Wal-
greens at 5.66 percent, a drop from 6.98
percent to 1.32 percent. These results
are consistent with Target and Walgreens
having the smallest and largest increases
in asset valuation after the conversion,
respectively.
Similarly, all but one of the airlines have
a reduction in their ROA, with US Air-
ways and United Continental exhibiting
the largest and smallest declines of 4.33
percent and 1.04 percent, respectively.
American Airlines actually experiences
a small increase of 0.86 percent in ROA.
This anomaly is due to the company
reporting negative equity as a result of
continuous operating losses.
In summary, this study provides con-
sistent evidence of the effects of lease
5LEASE CAPITALIZATION MAY/JUNE 2014 INTERNAL AUDITING
6. .......................................................................................................................................................
capitalization on a variety of financial
statement items and financial ratios
across companies and industries in the
first year after the accounting treatment
conversion. Our results suggest that a
company carrying large operating lease
obligations relative to its capital lease
obligations or ownership of its assets
will be most affected by the conversion.
The magnitude of the change also varies
depending on factors such as debt rat-
ing and lease term. Given that both indus-
tries make extensive use of operating
leases, the effects of conversion on fi-
nancial and operating results could be
significant enough to elicit negative reac-
tions from creditors and investors. For
example, the disproportionately large
percentage increase in liabilities rela-
tive to assets could lead to a substantial
increase in the debt ratio. In the case of
Walgreens, the combination of a 95.29
percent increase in assets and a 190.63
percent increase in liabilities would give
rise to a 49 percent increase in the debt
ratio, which could raise concerns about
potential violations of loan covenants.
Similarly, a nearly 64 percent drop in
Walgreens net income could potentially
trigger steep declines in stock price.
Looking ahead, should the FASB suc-
ceed in getting these proposed standard
updates implemented as they are cur-
rently written, it would benefit the cap-
ital market community if a public
awareness campaign were launched edu-
cating financial statement readers of the
effects of these changes in accounting
treatment of lease obligations and of the
anticipated reductions in income and
other key metrics. Without adequately
informing the shareholders of these
changes in accounting procedures, share-
holders may misinterpret the post-con-
version results and promptly sell off
shares, resulting in a rapid and signifi-
cant loss of capital. n
NOTES
1
“Statement of Financial Accounting Standards No.
13, accounting for leases, original pronouncements
as amended,” Financial Accounting Standards Board
(2008). Available at: http://www.fasb.org/st/.
2
Specifically, in order to be considered a capital
lease the arrangement must meet any of the four
following “bright-line” criteria: 1) the lease contains
a transfer of ownership at the end of the lease
term; 2) the lease contains a bargain purchase
option; 3) the lease term is equal to 75 percent or
more of the asset’s remaining useful life; or 4) the
present value of the minimum lease payments is
equal to 90 percent or more of the asset’s fair mar-
ket value. Criteria 3 and 4 are not applicable to an
asset leased in the last 25 percent of its total life
span. The term “bright-line,” with respect to rules
or guidelines, refers to rules that are clearly stated,
leaving no room for varying interpretations.
3
“FASB formally adds project to reconsider lease
accounting,” Financial Accounting Standards Board
(July 19, 2006). Available at: http://www.fasb.org/
news/nr071906.shtml (accessed March 3, 2013).
4
Sophisticated users of financial statements as they
are currently comprised will often manually adjust
the liability figures via estimation in order to account
for the off balance sheet obligations currently
reported only via the disclosures.
5
“2005 performance and accountability report,” U.S.
Securities and Exchange Commission (2005). Avail-
able at: http://www.sec.gov/about/secpar/sec-
par2005.pdf.
6
“Proposed accounting standards update: Leases
(Topic 840),” Financial Accounting Standards Board
(2010). Available at: http://www.fasb.org.
7
“Proposed accounting standards update (revised):
Leases (Topic 842),” Financial Accounting Stan-
dards Board (2013). Available at: http://www.fasb.org
8
Ibid., Appendix A, paragraphs B1–B4 and BC29–BC32.
9
Op. cit. note 6, paragraphs 25–27, 42–25, 60–63,
and BC142–BC159.
10
Details about the assumptions and methodologies
are available upon request.
11
Moody’s debt ratings are used to estimate the
imputed interested rate, a major input into the cal-
culation of the net present value of a capital lease.
12
“Economic impacts of the proposed changes to
lease accounting standards,” Equipment Leasing
& Finance Foundation (Dec 12, 2011). Available at:
http://www.leasefoundation.org/IndRsrcs/MO/Lse
Acctg/.
6 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION