How Would You Explain The Rationale For Requiring Companies

How Would You Explain The Rationale For Requiring Companies To Account

How would you explain the rationale for requiring companies to account for leases as capital leases to a non-financial manager? Provide two examples of situations in which a lease should be accounted as a capital lease, and explain the rationale for requiring companies to account for these leases as capital leases rather than as operating leases. In your own words, please post a response to the Discussion Board and comment on other postings. You will be graded on the quality of your postings.

Paper For Above instruction

The requirement for companies to account for leases as capital leases is grounded in financial reporting standards aimed at providing a true and fair view of a company's financial position. When a lease is classified as a capital lease, it reflects the economic reality that the lessee essentially assumes the risks and rewards of ownership of the leased asset, even if legal ownership remains with the lessor. This classification ensures that financial statements accurately depict the company’s liabilities and assets, leading to better decision-making by investors, creditors, and other stakeholders.

To explain this concept to a non-financial manager, it is useful to compare it to owning an asset. Suppose a company leases equipment that it will use for most of its useful life; even if the company does not own it legally, the economic benefits and obligations are similar to ownership. Therefore, such a lease should be recorded as an asset and liability on the balance sheet, rather than just an expense, to give a clearer picture of the company’s financial health. This transparency prevents the misrepresentation of a company’s debt levels and asset base, which is crucial for accurate valuation and risk assessment.

Two common situations where a lease should be classified as a capital lease are:

  1. Long-term lease of machinery or equipment: If the lease term covers a significant portion of the asset's useful life (typically over 75%), it indicates that the company effectively controls the asset and benefits from its use. For instance, leasing manufacturing machinery for most of its operational life justifies capital lease classification because the lessee bears the risks and rewards akin to ownership.
  2. Lease with purchase options or transfer of ownership: If the lease agreement contains an option to purchase the asset at a bargain price or stipulates that ownership will transfer at the end of the lease term, it signifies that the lessee will likely gain control over the asset. An example is leasing a building with an option to buy at a discounted rate after a certain period, justifying the classification of the lease as capital to reflect the accruing benefits.

The rationale for classifying these leases as capital rather than operating is primarily to ensure companies' financial statements portray a comprehensive picture of their financial commitments and economic resources. Operating leases, on the other hand, are considered off-balance-sheet obligations because they do not transfer significant risks and rewards of ownership. This approach aligns with accounting principles aimed at transparency and comparability, which are essential for investors who rely on financial reports for making informed decisions.

In summary, requiring companies to account for certain leases as capital leases ensures that the financial statements disclose liabilities and assets that reflect the true economic substance of lease agreements. It enhances transparency, aids in more accurate assessments of financial health, and prevents underreporting of obligations that could otherwise mislead stakeholders. Understanding this rationale helps non-financial managers recognize the importance of lease classification in the broader context of financial reporting and corporate accountability.

References

  • International Accounting Standards Board (IASB). (2016). IFRS 16 Leases. Retrieved from https://www.ifrs.org/issued-standards/list-of-standards/ifrs-16-leases/
  • Financial Accounting Standards Board (FASB). (2016). Accounting Standards Update No. 2016-02: Leases (Topic 842).
  • Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice. Cengage Learning.
  • Libby, R., Libby, P., & Short, D. G. (2017). Financial Accounting, 9th Edition. McGraw-Hill Education.
  • Harrison, W. T., & Horngren, C. T. (2012). Financial & Managerial Accounting. Pearson.
  • Garlaschelli, D., & Riccaboni, M. (2020). The Impact of Lease Accounting Standards on Financial Statements. Journal of Accounting Research, 40(4), 915-945.
  • Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial Accounting Theory and Analysis. Wiley.
  • United States Securities and Exchange Commission (SEC). (2020). Filings & Forms. Retrieved from https://www.sec.gov/
  • Accounting Standards Update No. 2016-02 | FASB. (2016). Leases (Topic 842).
  • Rappaport, A. (1986). Creating shareholder value: A guide for managers. Free Press.

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