It needs to be mentioned that there are certain theoretical basis for requiring lessees for the capitalization of long-term leases. The first theoretical basis is the transfer of ownership. According to the requirement of lease capitalization, it provides the lessee with the ownership of the asset at the end of the lease term. In most of the cases of industrial leases, this particular aspect can be seen. The next basis is called the bargaining of purchase option. In case the agreement of lease provides the opportunity of transfer of ownership at the end of lease term, then the lessee has the power to capitalize the lease without any further consideration (Bohušová, 2015). In this particular case, the price of the leased asset must be less than the fair market value. The next basis of capitalization is lease term. In case the lease agreement provides neither transfer of ownership nor the power to purchase, the lessee will still be able to capitalize the lease asset if it cover 75% or more of the expected life time of the asset. This is considered as a major theoretical basis of capitalization for the lessee. The next basis of capitalization is present value. The lessee has the power to capitalize the lease in case the lease is equal to or more than 90% value of the asset. However, the lessee will not be able to capitalize the lease in case the lease term is less than 75% of the expected life of the leased asset (Singh, 2012). The next basis of capitalization is specialized assets. In case of some specialized assets, the lessee has the power to capitalize the leased asset. However, in this case, the aforementioned criteria of leases need to be met.
As per the provided case study, SD International (SDI) plans to purchase a new building worth $25 million. However, due to the debt covenant of SDI with National Commercial Bank, SDI is facing difficulty to purchase the building. It can be seen that in case SDI purchase the building, the interest expense will be increased that will decrease the interest coverage ratio less than two (Barone, Birt & Moya, 2014). For this reason, the financial controller of SDI has suggested the solution of leasing the new building. In this situation, it needs to be mentioned there are both advantages and disadvantages of this suggestion. In case SDI accepts this, then the expenses will be shown as rent expenses and it will not affect the interest coverage ratio from any aspect. However, in this case, the company has to bear lease expenses as the fixed expenses similar to the interest expenses. Thus, it can be seen that in both of the cases, SDI will have to bear the same amount of expenses. However, in case of leasing the building, the interest coverage ratio will not be affected (Jackling, Howieson & Natoli, 2012). In addition, like financing the building, at the end of the lease term, SDI will get the ownership of the building. From the above discussion, it can be concluded that SDI should account for the lease in the suggested manner.
Barone, E., Birt, J., & Moya, S. (2014). Lease accounting: a review of recent literature. Accounting in Europe, 11(1), 35-54.
Bohušová, H. (2015). Is Capitalization of Operating Lease Way to Increase of Comparability of Financial Statements Prepared in Accordance with IFRS and US GAAP?. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 63(2), 507-514.
Jackling, B., Howieson, B., & Natoli, R. (2012). Some implications of IFRS adoption for accounting education. Australian Accounting Review, 22(4), 331-340.
Singh, A. (2012). Proposed lease accounting changes: implications for the restaurant and retail industries. Journal of Hospitality & Tourism Research, 36(3), 335-365.
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