Objectives and key issue of DE-242 The revised DE is aimed to improve the quality and comparability of financial porting by providing a greater transparency about the leverage, the asset that an entity used in its operations, and the risk to which it is exposed from entering into lease transactions (SAAB DE-242, 2013). Lessee Accounting The DE wants all leases to be recognized as right-of-use assets and lease liabilities, except short-term leases.
SAAB 11 7 only requires finance leases to be recognized on statements. This essay will focus on lessees and recognizing operating leases on financial statements as the DE affects them the most. Presentation of Statements Financial statements will include more lines of items as a result of capitalizing operating leases. Items include right-of-use-asset, lease liability, interest expense and amortization. This ensures quantitative information is provided to decision makers.
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Disclosures Additional qualitative information such as descriptions of leases is to be included on statements due to the overwhelming complexity for users to understand elements such as how variable lease payments are determined. Enhanced disclosures will assist users to understand the additional information to be presented on statements. Effects of DE-242 Recognizing operating leases Current situation Operating leases are a way to avoid on-balance sheet debt to make financial statements look more appealing (F;libber, Silva & Fertility, 2006, p. 1).
Beauties, Goodyear and Thomson (2000) estimated that operating leases were approximately thirteen times larger than finance leases. The attraction to classify leases as operating is the ability to manipulate ratios and thereby increase finance opportunities (Leo, Hogget & Sweating, 2012, p. 343) (Hartman & Same, 1989) such as low-interest loans. Duke, Whish and Us (2009) leased a study on capitalization of operating leases and found that companies hid billions Of dollars Of liabilities, enhanced retained earnings, income and ratios by reporting leases as operating.
Effects of capitalizing operating leases The effects of the DE are researched to gauge the impact of the changes and the usefulness of the new information provided to the user. Canadian studies resulted in the recognition of additional assets and liabilities on the balance sheet, increasing the debt-asset ratio and decreasing current ratio (Drencher, 201 0, up. 227-256). New Zealand studies on materiality indicated impacts on reported liabilities, therefore affecting leverage. It also showed decreases in liquidity and profitability (Bennett & Bradbury, 2003, p. 1 12).
US studies were done and reported back to the FAST comparing various lease capitalization techniques on five US corporations. The study summarizes that because of the necessary assumptions to capitalism leases, the capitalization can only be deemed an estimate, so as long as companies are not required to disclose the actual parameters (Biostatic, Evanescent & Coffee, 2013, p. 98). The DE will remove estimation uncertainties and provide users with an accurate picture of the company’s assets and liability obligations. It will also provide analysts with information that will enable informed decisions on the company’s worth.
However, capitalizing operating leases causes changes in equity which will affect investor and creditor decisions as to whether or not to finance a firm because of the increased risk being assessed (Beauties et al. , 2006, p. 82). But this allows users to properly assess a firm’s actual profitability, debt and risk levels when deciding if investing in the firm will lead o positive returns. Financial statement presentation Balance sheets For both types of leases, a right-of-use asset and lease liability is to be recorded.
Operating leases previously only needed to be expensed, thus misleading users about the firm’s profitability by overstating return-on-assets and understating debt-equity ratios (Tat, 2013, p. 128). Former SAAB chairman, David Tweeted, found billions of dollars worth of leases do not appear on balance sheets – hindering users to make informed decisions. The SAAB and FIRS believe that identifying the relationship between right-of-use assets and ease liabilities from the lease agreement provides useful information to users (Ernst & Young, 2013, p. 55) because leased assets are used similarly to owned assets.
Capitalizing right-of-use assets allows users to identify assets that play a role in profit mastication and liabilities owing – improving faithful representation in disclosures. Info, Lippie and Wright (1993, p. 362) found when trying to determine rockiness in a firm’s shares, stock market investors incorporate operating leases to aid their decision. Effectively, investors who previously did not have access to such information will now be provided with it. However, increasing assets and liabilities will result in lower return-on-assets (incorporating amortization) and higher debt-equity ratios.
Firms with large amounts of operating leases will face massive fluctuations on financial statements (Tat, 2013, p. 1 30) which will negatively affect decision makers to invest in the firm. P statements Type A leases require lease-related amortization and interest expenses incurred to be shown on two separate lines. For example, amortization such as rent expense, share different characteristics than interest expense thus it is logical to separate them. Rent expense is amortized against the liability whilst interest expense shows users the risk-return trade-off.
Currently, lease-related liabilities are only expensed. The new proposal will replace expenses with amortization and interest expense thus impacting EBITDA (PWS, 2010, p. 1) resulting in increased debt-equity ratios and lower return-on-assets due to net income decreasing and total assets increasing (Maharanis, 2011 , up. 64-65). The respective increases and decreases provide users with more accurate information on leverage, risk and profitability ratios because lessees will have to record amortization, offsetting he right-of-use asset, and interest expense.
Currently, recording them as one line of expense implies to users that assets are leased risk-free. Cash flow statements Cash payments for Type A leases are to be presented in ‘Financing Activities’. This shows users how lessees intend to finance the acquisition of right-of-use assets. Type B lease payments are to be presented in ‘Operating Activities’. This should reflect how the lessee plans to pay the lease liability Of the asset. (Ernst & young, 201 3, p. 4) The acquisition of a right-of-use asset will create an increase in operating cash inflows due to the asset being used in the production process of goods, resulting in revenue. By capitalizing operating leases, users can now accurately determine return-on-assets and debt-equity ratios. Cash flow statements are useful for users to identify how much money a firm has and how much they can borrow. If uncial statement disclosures Lessee accounting Devilries and Midfielder (2013, p. 1) point out deficiencies of AS-1 7 under the conceptual framework such as insufficient disclosures Of entities’ leasing activities.
The DE sets out new disclosure requirements of the reconciliations f amounts recognized in the statement of financial position, maturity analysis of discounted lease payments, and narrative disclosures about leases like information about the variable lease payments. (Ernst & Young, 201 3, up. 56-57). Some financial ratios may be altered since there are changes in the manner of ensuring decision-makers understand the overview of leasing activities such as reflecting the right-of-use asset and the lease liability (Devilries & Midfielder, 2013, p. 656).
New York University’s studies compared the effects of capitalization of operating leases resulting in lower net income due to interest and amortization, debt ratios increasing and lower return-on-equity. Thus the new requirements will increase the amount of information disclosed about leased assets and liabilities, including information about the basis, terms and conditions on determining variable lease payments, residual value guarantees and restrictions imposed by leases, which can improve the reliability and understandably of the financial statement for the users.