Impact of the new proposal on transparency
With regards to the operations of organizations involving in lease, it is clear that the proposed rule of including leases in balances sheet will foster transparency in reporting. The first instance that explains the effectiveness of lease accounting can be directed to the observed dominance of leasing. Leasing is a way for the subject entity to access financing and assets besides, minimizing risk exposure associated with ownership of asset. This prevalence indicates that leasing now forms a significant fraction of company’s operations and thereby influences the profitability of the subject organizations. This means that the users of financial statements will equally need to know about the implication of the leases in a company’s report. For instance, the companies’ needs to account for the amount received or spent in leases within the financial statements to allow the stakeholders to determine how this will affect their stake in the organization. In which case, the users need to have clear picture of the company’s activities represented by leasing. The US Securities and Exchange Commission supported this fact by stating that the changes made to reflect leasing is a way for promoting transparency in reporting of a company’s financial activities.
The proposal can also be seen as a way of promoting transparency because it presents platform for comparing financial reporting made by companies within an industry. According to FASB, through reporting leases, the users are better placed to compare various companies based on the leverage and risk exposure arising when these firms enter into a leasing contract. The initial standards only accounts for capital leases, lessees accounts for leases asset and liabilities on the balance sheet (Ma, 3); however, there is no reporting for operating leases arising associated with assets and liabilities on the balance sheet. This is where the new proposal sets in as a platform for achieving transparency because it directs lessees to account for assets and liabilities associated with all leases. In turn, transparency is directly related to the ability of the investors and financial statements’ users to visualize the true picture of the company’s operations.
Besides the reporting, the new proposal also features a rule, which requires disclosures. These disclosures would make it easy for investors and financial statements’ user to grasp information regarding amount, timing, and cash flows’ uncertainty originating from leases (Ma, 5). The disclosures also integrate a recommendation for modification to the way in which lessors of equipment and vehicle would report for leases considered off-balance sheet. According to FASB, this is a blueprint for greater transparency regarding the exposure of such lessors to risk associated with credit and assets. By promoting transparency, as discussed above, the new rule comes out as a factor to foster reliability and usability of financial statements by the users and investors.
Impact of the new proposal on airline and construction industries
So far, the studies carried shows that the new proposal would negatively influence airline and construction industry. In which case, the impact is considered to come in form of lowered profits and decreased net assets. This majorly arises because the new rule directs the lessee to integrate lease on the balance sheets indifferent to old lease accounting rules that places liabilities off their balance sheets (Ma, 6). For instance Southwest Airlines, as of December 2008 reported operation of 92 leased aircraft, whereby 82 of these were operating lease. This represents 15% of the total fleets. This fraction is likely to be impacted with the emergence of the new rules, with the additional assets and liabilities on the balance sheets. The aircraft leased by Southwest are also known to be older models.
With the proposed lease accounting model, the present value of the leased rents will be recognized as asset and liability (Ma, 14). In such a case, interest expense and amortization would be used in place of rent expense. Higher expense on interest occurring at the beginning of year’s lease would take effect in addition to lease’s longer term; consequently leading to more expenses that are frontloaded. For instance, in a case where Delta possess an aircraft lease that is of 17 year old, the present value attached to the rents will be capitalized at 80%-89% of cost assuming a 7% discounting rate (Ma, 7). With calculation, for $100 million worth aircraft lease, the expense in first year will be recorded as $2.4 million; implicating a record of 26% above the straight line.
With regards to the new proposal, the reporting of all operating leases would be recorded in form of assets and liabilities. The lease term therein would comprise of both optional renewal periods and non-cancellable periods (Ma, 7). For an airline or a construction company, most of the leases are made of rental escalation clauses, which need to considered as important. Further, minimum lease payments for these companies include estimation of renewals, rents considered contingents and guarantees on residual as part of liabilities and assets (Ma, 7). These estimates would impact negatively on the companies because of the costs involved besides the higher volatility in profit or loss. Further, the right-of-use model lessees and de-recognition approach required from the lessor would also present a challenge to the company when making decision regarding estimation of rentals.
Ma, Wenqi. Impact on Financial Statements of New Accounting Model for Leases. 2011. University of Connecticut - Storrs