The classification of lease arrangements as either finance leases or operating leases determines the accounting treatment of transactions associated with the lease. For finance leases, the lessee recognizes an asset and liability at the inception of the lease. The leased asset is subsequently depreciated and the liability is reduced through rental payments. An annual interest charge is recognized in respect of the liability. For operating leases, the lessee treats rental payments as expenses.
These divergent accounting treatments provide an incentive to managers to classify lease arrangements as operating leases. Finance leases may have the following adverse impacts on a lessee entity’s financial statements or on decisions made by users of those statements.
• The capitalization of the leased asset increases the value of reported non-current assets and reduces the return on assets ratio.
• Recognition of the present value of future lease payments as a liability increases reported current and non-current liabilities. This adversely affects debt–equity ratios and liquidity–solvency ratios, 420such as the current ratio (current assets/current liabilities). Reporting increased liabilities may result in entities breaching debt covenants, thereby causing debts to become due and payable immediately.
• Subsequent depreciation and interest expenses may exceed rental payments and result in lower profits being reported in the early years of the lease.
• Depreciation and interest expenses are not deductible for tax purposes, so additional liabilities may have to be recognized under IAS 12 Income Taxes when these expenses are less than the deduction for rental payments.
• More onerous disclosure requirements are prescribed for finance leases.
The ability to manipulate gearing ratios and thereby possibly reduce the cost of capital or increase the availability of finance for an entity is the most significant reward of keeping financing arrangements off the statement of financial position by classifying them as operating leases.
As a result, since the release of IAS 17, the leasing industry has been geared towards promoting lease structures or arrangements that meet the guidelines for classification as operating leases. Classification and the subsequent accounting must be based on substance and financial reality and not merely legal form. Hence, after considering the guidelines, which concentrate on the form of the lease agreement, the process of classifying a lease must include an analysis of the substance of the lease arrangement.