Abstract
The current study is undertaken to investigate the potential problems resulting from the proposed adoption of a new accounting standard concerning mandatory capitalization of all lease contracts. In 2010, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) issued a joint exposure draft (ED2010/9) on accounting for leases. Under the new standard, lessees are required to capitalize all lease contracts as assets and liabilities. The distinction between operating leases and capital (finance) leases will no longer exist. The long-standing off-balance sheet treatment of operating leases will be prohibited. After the adoption of the proposed standard, companies with significant operating leases are likely to experience an increase in assets, increase in liabilities, and decrease in equity, resulting in the deterioration of their return-on- assets and debt-to-equity ratios. This research examines two large fast-food restaurant chains based in Hong Kong; and through constructive capitalization, demonstrates how the companies’ key financial ratios are negatively impacted if the new standard is implemented. The results indicate that both the return-on-assets and debt-to-equity ratios of the two companies, under various discount rates assumptions, suffer serious deterioration when their operating leases are capitalized.
Highlights
Accounting for leases has been a controversial issue for decades among academics, standard setters, corporate management, and financial statements users
Non-cancellable leases that meet one or more of the following four criteria must be capitalized by the lessees: (1) there is a transfer of ownership of the lease asset from the lessor to the lessee at the end of the lease term, (2) there is a “bargain purchase option,” (3) the length of the lease term is 75% or more of the asset’s expected economic life, or (4) the present value of minimum future lease payments is 90% or more of the asset’s fair value at the inception of the lease agreement
In 1996, the G4+1 Group issued a special report in which it proposed a single lease accounting method to eliminate the distinction between operating and capital leases and recognize an asset and a liability equivalent to the fair value of the rights and obligations conveyed by the lease
Summary
Accounting for leases has been a controversial issue for decades among academics, standard setters, corporate management, and financial statements users. In 1996, the G4+1 Group (consisting of accounting standard-setting bodies of Australia, Canada, New Zealand, United Kingdom, and the United States, plus the International Accounting Standards Committee) issued a special report in which it proposed a single lease accounting method to eliminate the distinction between operating and capital leases and recognize an asset and a liability equivalent to the fair value of the rights and obligations conveyed by the lease. The new proposal consists of a ‘‘right-of-use’’ accounting model to substitute for the “ownership” model, where the lessees recognize assets and liabilities arising from all lease contracts These assets and liabilities would be initially measured at the present value of future lease payments. In the likely event that the new IASB/FASB standard on lease accounting will be adopted in the near future, how should Hong Kong companies prepare themselves to face the possible fatal blow caused by the sudden deterioration of their financial ratios?
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