IM_CH_17 - Chapter 17 Leases Instructor's Manual CHAPTER...

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Chapter 17: Leases Instructor’s Manual 7 th edition Page 1 of 17 CHAPTER HIGHLIGHTS Lease capitalization is one of the most interesting policy areas in accounting. This is because of the gradual evolution of policy over a long period of time (nearly 40 years). Such a long evolution permits a ready analysis of the theoretical rationale behind the successive accounting standards. The overriding issue presented in the chapter is the search for finite uniformity. In the case of leases, this means classification of the leases as either capital or operating leases. Capital leases are likened to purchases. By simple analogy, operating leases are made to resemble rentals. This simple two-way dichotomy illustrates the limitation of the accounting model. Leases are obviously neither purchases (sales) nor simple rentals in the strict legal sense. Yet the accounting choice is limited to these two analogies. Given the large number of successive lease accounting standards, the chapter presents a historical development of the arguments pertaining to lease capitalization. This review also illustrates the importance of definitions of accounting elements. The trend toward increased capitalization is closely related to the broadening of asset and liability definitions over the same time period. What emerges from the review is that finite uniformity is difficult to define and implement where there is a continuum of possibilities. The rules of capitalization emerge as an arbitrary point in the continuum; for example, the 75 percent rule in SFAS No. 13. Another important point is the incentive to circumvent lease capitalization, and the ability to do so by defeating the various (arbitrary) capitalization tests. This latter point illustrates a practical weakness in the policy of finite uniformity, and has led many critics to advocate an “all or none” attitude toward lease capitalization (rigid uniformity). The final point to be highlighted concerns the incentives to circumvent capitalization, and the economic consequences of mandatory lease capitalization. Survey evidence indicates a management preference for noncapitalization in order to achieve “off-balance-sheet” financing. There is some evidence that the market was “fooled” by hidden lease contracts: a study of APB Opinion No. 31 by Ro (1978) found evidence that its adoption had “information content” and that security price responses were negative. This could be explained in terms of the revelation of hidden debt. Another study (Pfeiffer, 1980) also found a negative price response to securities during the FASB’s public hearings in late 1974. It was argued that debt covenants would have affected stockholders wealth due to dividend and other restrictions relating to debt levels. In spite of the apparent market effects earlier, there was no evidence that the actual implementation of SFAS No. 13 affected security prices (Abdel-Khalik, 1981). This body of contradictory research can be reconciled.
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IM_CH_17 - Chapter 17 Leases Instructor's Manual CHAPTER...

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