Accounting bodies, both international and national, require leases to be classified in terms of economic substance rather than legal form.
Current regulation distinguishes a finance lease from an operating lease. If a lease transfers the risks and rewards of an asset to the lessee, it is a finance lease. Otherwise, the lease is an operating lease. A finance lease appears in the balance sheet; an operating lease may remain off the balance sheet.
The change will eliminate a sometimes artificial distinction, but higher reported leverage may have ill effects. Management may avoid otherwise desirable leasing to protect the leverage ratio. Bond covenants may be breached and need to be renegotiated. There may be an incentive to circumvent the standard by taking out a succession of short but renewable leases.
Anti-avoidance tax legislation proliferates daily and will probably increase as governments seek every opportunity to raise revenue in straitened times. At worst, a measure will be retrospective. Planners should monitor discussion and attempt the difficult task of identifying and anticipating the most likely changes, including anti-avoidance legislation.
Lease accounting is nearer than ever to its goal of reporting substance rather than form. International regulators and their national counterparts agree that right-to-use rather than legal title should determine the classification and treatment of leases. The choice is essentially between disclosing a lease as a financial instrument on the balance sheet or as an operating lease on the income statement.
Financial reporting of leases is addressed in the International Accounting Standards Board’s International Accounting Standard IAS 17. The International Accounting Standards Board (IASB) benefits from the participation of many countries, including the US Financial Accounting Standards Board (FASB).
Why lease? Management needs to test conventional answers carefully since some have limited relevance, while others are frankly contestable. Leasing is sometimes promoted for its small initial outlay, even as 100% financing. This ignores the fact that a rational lessor like a lender will seek a cushion of equity to protect the finance provided. A more rational answer is that leasing is advantageous if it provides more finance than the borrowing which it displaces. Management is essentially asking how far, for their company, is leasing a substitute for borrowing and how far a complement. Research suggests that leasing tends to be a substitute for borrowing for larger firms and a valuable complement to borrowing for small and medium enterprises (SMEs). Leasing can help to overcome SMEs’ difficulty in conveying their quality to would-be financiers.
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