A lease is a contractual agreement between a lessor and a lessee whereby the lessor (owner) provides the lessee (user) the right to use an asset for a certain period of time, in return of compensation, usually in the form of specified, periodic cash payments for the duration of the lease. A typical lease transaction is the rental of office space. Usually, in such a lease, the lessor retains ownership of the asset. Leases of this type are referred to as operating leases. Leases whereby the sale of the asset leased is essentially effected are termed as finance leases or capital leases (as per American standards).
Such transactions in the Philippines are governed by PAS 17, Accounting for Leases. These standards provide for certain accounting rules that may allow scope for creative accounting, specifically in the classification of leases as either finance or operating lease. Although the Standards do not give specific, clear-cut criteria as to how to classify leases, this lack of specificity makes much room for subjectivity on the part of the parties involved.
Current Accounting Treatment
As provided in PAS 17, “a finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset” (PAS 17, par. 4).
It also provides examples of situations which are indicative of a finance lease (PAS 17, par. 10):
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a) The lease transfers ownership of the asset to the lessee by the end of the lease term;
b) The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised;
c) The lease term is for the major part of the economic life of the asset even if the title is not transferred;
d) At the inception of the lease the present value of the minimum lease payments amount to at least substantially all of the fair value of the leased asset;
e) The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.
Leases that do not meet any of the above criteria (and other criteria as provided in PAS 17 par. 11) are classified as operating lease.
This distinction between the types of leases is important because both types have very different effects to the parties’ balance sheets. A finance lease is recorded as an asset and liability in the balance sheet of the lessee at an amount equal at the inception of the lease to the fair value of the leased property or, if lower, at the present value of the minimum lease payments. The lessor, on the other hand, recognizes the lease as a receivable at an amount equal to the net investment in the lease.
An operating lease is recorded simply as an expense (lessee) or revenue (lessor) in the income statement, usually on a straight line basis over the lease term.
There are also certain tests not included in the Standards that are very often used in determining whether a lease is a finance lease. The 90% test provides that if the present value of the party’s minimum lease payments equals 90% or more of the leased asset’s value, the lease is considered as a finance lease.
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There is also the 75% test wherein a lease is classified as a finance lease if the lease term runs for 75% or more of the leased asset’s economic life.
Clearly, the rules in PAS 17 are very subjective and many companies have used this loophole to their advantage. Many have hidden large debts in the disclosures in their financial statements because their lease contracts have not met the finance lease criteria. The Reuters Research has determined $482 billion debts for lease contracts for the S&P 500 through a Wall Street Journal review of the companies’ annual reports. This figure is about 8% of the companies’ total reported debts.
The difficulty in the current standards is that the Standards do not provide clear measures as to the classification of leases. The application of the Standards using the term “substantially all” can be very subjective and vague. What an accountant of one company may judge as substantially all may not be the same as another accountant’s judgment. This may cause accountants to increase their levels of being “substantially all” and just find justification in doing so, so as to prevent them from recording the lease as a finance lease.
Although there are tests, more specifically, the 90% test, that are more often than not, considered to be rules as well, problems may still arise. The 90% test presents “on-off switches” that are relied on too much. The problem with this is it is too clear-cut that slight variations can make a lot of difference. Say a lessee persuades its lessor to slightly lower the periodic payments so as to result in the present value of minimum lease payments to be just 89.9% of the fair value of the asset, therefore classifying the lease as an operating lease.
The same also may be said of the 75% test. One month or even one day less of the lease term, a lease transaction may be considered as an operating lease. These loopholes allow companies to easily structure transactions to achieve their desired outcomes.
These problems may be very vulnerable in the Philippines. Not to generalize and demean Filipinos, but it is quite certain that these loopholes will be exploited, especially in times when companies would want to appear “much better off” than their competitors.
Obviously, there is a need to revise the Standards for leases to take into account the problems of ambiguity of the standards and the exactness of the adopted “rules”.
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Perhaps the Standards could include the 90% test but use a range of percentages rather than a single percentage. Say, if the present value of the minimum lease payments would be less than 70%, the lease would automatically be considered as an operating lease. If it equals 90% and above, then it would be classified as a finance lease. If the present value falls between 70% and 90%, additional indicators may be considered, like the option of canceling the contract, or be made a case-to-case basis. This way, the problem of subjectivity is minimized and the occurrence of manipulated transactions is prevented. The same may be done for the 75% test.
However, providing such a range would entail much study of lease transaction so as to provide a reasonable range to use.
Cledon, Tom. Accounting for Leases. February 1, 2000. Student Accountant Online Journal. Downloaded from www.acca.com
Cledon, Tom. Accounting for Leases Part 2. March 1, 2000. Student Accountant Online Journal. Downloaded from www.acca.com
International Accounting Standard IAS 17. 1997. International Accounting Standards Council (IASC)
Philippine Accounting Standard PAS 17. 1997. Philippine Accounting Standards Council (PASC)
Spiceland, J, Sepe, J., Tomassini, L. 2001. Intermediate Accounting 2nd Edition. McGraw-Hill Book Co. Philippines.
Valix, C., Peralta, J. 2004. Financial Accounting Volume 2 2004 Edition. GIC Enterprises & Co., Inc. Manila, Philippines.
Weil, Jonathan. How Leases Play a Shadowy Role in Accounting. http://online.wsj.com. September 22, 2004. The Wall Street Journal.