Essay: Operating Lease Practices In Capital Markets Assessment.

1. Identify the social and corporate imperatives that underlie the accounting conceptual framework

2. Explain the relationship between accounting theory, the accounting conceptual framework and accounting standards

4. Work individually and in groups to identify and apply appropriate accounting standards to a range of authentic accounting scenarios 

Fundamental Characteristics

The objective of this report is to assess how the capital market participants use operating lease in the off-balance sheet at the time of evaluation of the credit risks of the organizations. The study will focus on the risks that are associated with the operating lease. It will also focus on the accounting information and its treatment in the balance sheet with regard to the operating lease. From the economical aspect, the account standard setters accounts for the financial lease and operating lease in the same way.  As existing standard for lease results into asymmetry as well as inaccuracy regarding the market information, this report will focus on the release of new accounting standard for lease that is released by IASB and FASB.

Fundamental characteristics

Accounting standards 16 on leases issued by the AASB introduced a single accounting method for leases and needs that the lessee to recognize the liabilities and assets for the leases with > 12 months period unless underlying asset value is very low. Liabilities and assets from the lease are primarily measured at the present value.

The fundamental characteristics of AASB 16 on operating leases are as follows -

The measurement involves the payments with regard to the non-cancellable lease and the payments related to the optional periods in case the lessee is quite sure that the option of extending the lease will be exercised or will not exercise the terminate option of lease (Altamuro et al., 2014). The AASB 16 includes the requirement of disclosures for the lessees. AASB 16 needs the enhanced disclosure that is to be delivered by the lessor that will improve the information disclosed regarding the risk exposures of the lessor, specifically with regard to the risk associated with residual value (AASB Standard - AASB 16 – Leases, 2017)

Accounting for the activities of corporate leasing are debated and examined for more than last 30 years. At present the IASB (International Accounting Standard Board) as well as FASB (Financial Accounting Standard Board) are implementing the standards for modifying the financial reporting with respect to the operating leases that are at present reported as off-balance sheet item. With regard to the proposal of Spencer and Webb (2015) analysed the existed literature to forecast the expected impact of any alteration (Bratten, Choudhary & Schipper, 2013). They studied the existed studies for understanding the fact that why the firma engage them in the operating leases and how the information related to these have its impact on the users.  They also reviewed the reports directly related to the leases. As per the review reports, the companies engage themselves in the off-balance sheet activities for leasing in parts for managing the presentation of financial statement (Andrade, Henry & Nanda, 2014). However, as per the other study it is suggested that the organizations use the operating leases for managing the cost and to preserve the capital. Generally, the study suggests those credit rating agencies, lenders and various other participants of the capital markets understand the off-balance sheet leases efficiently and consider them in the process of decision making (Callahan, Smith & Spencer, 2013). Further, Spencer and Webb provided the details regarding current proposals and the current point of the IASB and FASB divergence that includes the segregation of the expenses related with the operating leases. Where IASB suggests disaggregating the amortization elements and interest, FASB suggested reporting the single and combined expenses for lease. However, not much importance has been given with regard to the expenses that are associated with the operating leases. However, the existing studies suggest that the disaggregation of information with regard to the financing and operating activities is crucial. The review of the author is useful for the regulators as reporting standards for the operating leases are debated (Spencer & Webb, 2015).

Accounting Standards 16 on Leases

The lease payments from the operating leases shall be recognized either on the straight line basis or any other systematic basis. Therefore, the lessor shall apply any other systematic basis if that method is more appropriate. The lessor shall identify the costs inclusive of depreciation that are incurred for earning lease income as expense. The lessor must add the initial direct costs that are incurred for obtaining the operating lease at the carrying amount for the underlying asset and it recognizes the costs as the expense over term of lease on similar basis as of the income. The policy of depreciation for the underlying depreciable asset is subject to the operating leases must be inconsistent with lessor’s normal policy of depreciation for same type of asset. The lessor must calculate the depreciation as per the AASB 138 and AASB 116. The lessor must apply the AASB 136 for determining whether the underlying asset that is subject to the operating lease is impaired and accounting for the identified impairment loss, if any. The dealer or the manufacturer does not identify the profit from selling the asset while entering into the operating lease as it is not equal to the sale (AASB Standard - AASB 16 – Leases, 2017). 

The lessor must take into consideration the modification with regard to the operating lease as the new lease from effective date of modification, concerning the accrual or prepaid lease payment with regard to original lease as the part of lease payments for new lease. The disclosure objective for the lessor to disclose the information in form of notes, together with information provided in financial position statement, cash flows statement, profit or loss statement and it gives the basis for the users of the financial statements for analysing the impact of the leases that it have on financial performance, financial position and the cash flow of lessor (AASB Standard - AASB 16 – Leases, 2017).

The disclosure objective for the lessor for disclosing the information under the notes along with the provided information in the financial position statement, statement for the profit and loss and the cash flow statement gives the idea regarding the assessment of the impact that have on financial position due to leases (Müller, Riedl & Sellhorn, 2015). A lessor must disclose the amounts for reporting period with regard to the selling loss or profit, financial income on net investment in leases and the income with regard to the variable payments of lease are not included for measuring the net investment for lease. For the operating leases, incomes that are separately disclosed and the lease income with regard to the variable lease payments that are not depended on the rate or index. Further, the lessor must disclose the additional quantitative and qualitative information regarding the leasing activities that are required to meet the disclosure objective. The additional information involves the characteristics of the leasing activities of the lessor and the way in which the lessor disclose the strategy for risk management and it includes the means through which the lessor decreases the risk (Kusano, Sakuma & Tsunogaya, 2015). These means may include residual value guarantees, buy-back agreements or the payments related to variable lease for the use of over the limits.

Credit Rating Relevance of Operating Leases

The operating leases were actually associated with the credit ratings and the reliability of the accounting related information has considerable impact on the risk associated with the operating leases. The study of Spencer and Webb reclassified the credit rating into seven categories ranging from AAA (1) to CCC or lower (2). The main findings of the study are that the operating lease is relevant and have same relevance with the risk as the finance lease when the disclosures of the operating lease are reliable (Financial Accounting Standards Board (FASB), 2016). Further, reliability of accounting information has an impact on the risk relevance of the operating leases for the purpose of explaining the credit risk. For estimating the amount of operating lease obligations, the present value method presumes that the amount of lease payments is constant throughout the lease term while the operating lease is constructively capitalized (International Accounting Standards Board (IASB), 2016). However, when the organization has various lease contracts entered at various periods, the payment amount of lease reduce gradually as each contract has the expiry time. However, even after the reclassification of the constructive method of capitalization and credit rating the outcome does not alter with the findings (AASB Standard - AASB 16 – Leases, 2017). 

Conclusion 

It is concluded from the above discussion that the operating leases are linked and depended on the credit ratings. Apart from this, the finance leases and the operating leases are processed similarly at the time of determining the credit ratings. However, the risk approach of the finance lease considerably varies with the risk approach of operating lease. Moreover, the capital market indicates that the operating lease from off-balance sheet is considered while assessing the credit risk of the firm and disclose it reliably. Finally, the study told about the impact of capitalizing the operating lease on the credit rating. Irrespective of the valuable insight for the disclosures of operating lease and its disclosures have various limitations. For example, it was found that the accounting information’s reliability had considerable impacts on the risk approach with regard to the operating lease through usage of the remaining lease contract for the lifetime with the proxy for the reliable information. The FASB and the IASB issued the new accounting standard for the lease that needed the lessees for recognizing all the assets approximately, for instance the operating leases and the finance leases under the balance sheet (IASB, 2016; FASB, 2016). If these circumstances are considered, the reliability of the accounting information has an impact on the risk relevance of the operating lease. Such analysis provides more comprehensive details with regard to the capitalization of the operating leases.

Reference 

AASB Standard - AASB 16 - Leases. (2017). Australia. Retrieved from https://www.aasb.gov.au/admin/file/content105/c9/AASB16_02-16.pdf

Altamuro, J., Johnston, R., Pandit, S., & Zhang, H. (2014). Operating leases and credit assessments. Contemporary Accounting Research, 31(2), 551–580.

Andrade, S. C., Henry, E., & Nanda, D. (2014). The impact of operating leases and purchase obligations on credit market prices. Working Paper.

Bratten, B., Choudhary, P., & Schipper, K. (2013). Evidence that market participants assess recognized and disclosed items similarly when reliability is not an issue. The Accounting Review, 88(4), 1179–1210

Callahan, C. M., Smith, R. E., & Spencer, A. W. (2013). The valuation and reliability implications of FIN 46 for synthetic lease liabilities. Journal of Accounting and Public Policy, 32(4), 271–291.

Financial Accounting Standards Board (FASB)(2016). Accounting Standards Codification (ASC) Topic 842, Leases. FASB

International Accounting Standards Board (IASB) (2013). Exposure Draft, Leases. IASB.

International Accounting Standards Board (IASB) (2016). International Financial Reporting Standards (IFRS) No. 16, Leases. IASB.

Kusano, M., Sakuma, Y., & Tsunogaya, N. (2015). Economic impacts of capitalization of operating leases: Evidence from Japan. Corporate Ownership and Control, 12(4), 838– 850.

Müller, M. A., Riedl, E. J., & Sellhorn, T.(2015).Recognition versus disclosure of fair values. The Accounting Review, 90(6), 2411–2447.

Spencer, A. W., & Webb, T. Z.(2015). Leases: A review of contemporary academic literature relating to lessees. Accounting Horizons, 29(4), 997–1023.