Jim Evans, the CEO of Accord Capital Group takes on the new changes introduced by the accounting standards board regarding operating leases. Being a manager of a small firm that lends assets on a lease, Jim is concerned about the place of new rules while the old rules were advantageous for small firms. His discussion may be summarized in the following points:
- The advantages of off-balance sheet financing for small firms
- Critique of depreciation charge as regular
- Critique of the ‘noncancelable’ notion of the lease
- Critique of the requirement of setting asset and liability accounts based on discounted amounts
- Need for a clear distinction between lease and loan
Operating leases are often termed as off-balance-sheet financing, as the value of the asset does not appear on the balance sheet of the lessee. The lessee charges rental expenses at each year-end. Jim is of the view that this practice is used as a margin control by small firms as they are able to record an expense when it is paid. Therefore they can establish an expense that they can record at variable lengths to better match the revenues. The very principle of “matching’ in accounting is better satisfied when small firms are allowed to charge an irregular rent. What is shown as a result is a true margin, instead of a mirage that gives an untrue picture of revenues and expenses.
Depreciation also is a charge that is recorded regularly, without considering the actual use of the equipment. This also gives an untrue picture of the real position of the firm. Firms should be allowed to place the expense at the same time as the revenues that would enable them to better control and manage the return on their assets. Operating leases helped firms to do the same. They enabled them to better match the expense with revenues, and also to price their products.
Jim is also concerned about the board’s requirement of setting proper asset and liability accounts on the balance sheet for the leased equipment. He objects to the notion of ‘non-cancelable’ for the rent payments that would empower the lessor to have an early termination of the lease by larger payment and also return of the equipment. In this regard, the actual liability on the balance sheet should be the amount of total renal payments, instead of the discounted amounts. The amount for an asset should be the same as well.
Jim emphasizes the need for a clear division of accounting rules for lease and loans. He suggests that for leased equipment, there should be some residual amount appearing on the balance sheet to ensure that the lessee bears some risk. The accountants will also have something to analyze the equipment with.