For many decades now leasing has been a reasonable alternative to buying when a business wanted to acquire assets. Whether for cash flow, tax or flexibility reasons, leasing provides needed choices for firms. Then FASB & IASB decided to change the rules because they felt some major firms were abusing the system.
What? Capital leases were intended to be similar to buying [finance a building over its useful life] where operating leases were more like short-term rentals of convenience [Airbnb].
These 2 financing vehicles were intended to serve different purposes. Yet an increasing number of firms were gaming the system by pretending (booking) capital leases as if they were operating leases. Why? Because operating leases require no balance sheet recording so these businesses were, in effect, understating their true liabilities. Both current & long term.
This meant that both lenders & shareholders may have been making financial decisions based on incorrect [inaccurate] financial reporting. Some say these firms mislead their providers of capital.
How? Let’s set the scene.
• Operating leases are:
o Balance sheet – No recording
o Income statement – The lease payment is expensed.
o Cash flow statement – CFFO includes the lease payment
o Disclosure – not required
• Capital leases are
o Balance sheet – Capitalized
o Income statement – Depreciation & imputed interest expensed
o Cash flow statement – CFFO: interest; CFFF: principal
o Disclosure – required
The reaction? The short version is FASB (Financial Accounting Standards Board) & IASB (International Accounting Standards Board) declared all leases would be capitalized. The consequence? Thousands of firms screamed that they would immediately be in violation of their loan covenants. The response? These accounting authorities backed off & stated, “we’ll take this under further advisement”.
Fast forward with a couple of years of public comment & the 2 organizations are about to release their latest decision on leasing. They don’t agree with each other.
Yet will it be clear? FASB will continue to allow 2 types of leases. IASB has decided all leases are effectively capital leases.
So what’s the problem? It will take years (prior to 2019) for US firms to complete the transition to the new leasing rules. Just about that time we will be required to change again to move to International Financial Reporting Standards (IFRS), as we have agreed to do. Confused? Me too.
So when is a lease a lease; or not?