All leases may have to soon be disclosed on the balance sheet if an exposure draft on lease accounting is adopted. These lease accounting changes will affect the printing industry dramatically. The draft would eradicate the distinction between operating and capital leases and result in all leases being reported on the balance sheet which will materially lower many current ratios (current assets/current liabilities) as the current portion of operating leases (next 12 months’ payments) does not currently show as a current liability. Critics of the current rules say they allow too many leased assets to be invisible, thus many financial statements do not accurately reflect a company’s true financial picture. I wholeheartedly agree. For a wonky discussion of this topic, read on. For everyone else, know that changes could be brewing that will dramatically effect most current ratios.
Currently there are two types of leases: capital and operating.
A capital lease is treated the same as any loan for equipment where the asset is added to the company’s balance sheet and the lease payments are considered as liabilities, split into current and non-current portions. Then, as payments are made, the lease liabilities (notes) are reduced and interest expense is recorded. Depreciation is also recognized.
An operating lease, however, is not recorded on the balance sheet, thus does not show up as a liability, although all leases are disclosed in footnotes to a full set of business financials. Most private companies, however, do not prepare full financials, therefore, it is not disclosed.
These operating leases are best illustrated as a building lease. Most companies have them, but they don’t show up as a liability. Rather the building rent is paid and expensed on a monthly basis and only shows up on the balance sheet if rent has not been paid. (Overdue rent typically is included in accounts payable). What’s not disclosed is that the lease is a five-year obligation of the business, with 12 months of rent being a current liability and the rest non-current.
This, then, understates the current liabilities and overstates the current ratio (current assets divided by current liabilities), making the business look stronger than it is.
Realistically, building rent isn’t the issue. What is at issue are the many equipment leasing deals entered into by businesses that effectively hide debt from readers of the financial statements.
The current theory is that operating leases are merely rent payments. Since one is not actually purchasing the equipment, rather renting it over a period of time (usually three to five years), and since there is a fair market buy-out at the end, this transaction is rental expense and does not need to be recognized. If, on the other hand, there would be an expectation that the business would keep the equipment at the end of the lease ($1 buy out, for instance), then that makes it a true purchase, and it should be disclosed (capitalized by recognizing the asset and liability on the balance sheet).
Here’s the problem with the theory, and it’s not building leases (rent). Many companies lease most of their equipment through these operating leases. Thus, the long term liability (the five years’ worth of rental payments) is not reflected as a liability.
There was a period in the late 1980s when lease payments would be recognized using a prepaid interest method which, in my opinion, more properly reflects the asset and liability. While it is unknown what method would be used to recognize these leases under the reform, I assume it would probably follow this previous method.
Simplified Prepaid Interest Example: A $1,000 lease for 60 months would be recognized as a total $60,000 liability, as it truly is on day one. $12,000 of that liability would be current, with the remaining $48,000 non-current. As each $1,000 payment is made, it would be deducted from the non-current portion of the liability through the 48th month when the non-current liability would be zero. Payments through payment 60 would reduce the current portion until it, too, was zero.