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Describe what are the scope and nature of the issue on the lease capitalisation in accordance...

Describe what are the scope and nature of the issue on the lease capitalisation in accordance to Wong and Mahesh Joshi?

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Let us understand and clear our basics first before we jump into this ocean of discussion.

Meaning of Leases: A lease is a contract wherein one party agrees to rent property owned by another party. This contract guarantees the lessee (tenant) to use an asset and it guarantees the lessor a sum of regular payments for the agreed period for that particular property.

There are two types of Leases: Operating Lease and Capital Lease (Finance Lease)

1. Operating Lease: These leases are often called as Service lease as well and they are short term lease. The rental cost of an operating lease is considered as Operating Expenses. The lessee uses the property but the ownership of the asset remains with the lessor.

2. Finance Lease: In this lease, the ownership of the asset is reflected in the company's Balance sheet. This is in contrast to the Operating Lease, it is treated as a purchase from the standpoint of a person who is leasing and Loan from the person who is offering the lease. These are for Long term, unlike Operating Leases.

How to Identify if the Lease is a Capital Lease: As per the Financial Accounting Standards Board to fall into Capital Lease one of the following these conditions need to be fulfilled:

a) Title passes automatically to the lessee by the end of the Lease term

b) The term of the lease is greater than 75% of the useful life of the equipment.

c) The present value of lease payments is greater than 90% of the fair market value of the equipment.

d) The lease has an option to purchase the equipment at the end of the period at the bargain price.

Scope and Nature of Lease Capitalisation: As per Wong and Mahesh Joshi if the Lease Capitalisation is brought as a Standard it will change the way leases are being recorded and reported in the Financial Statements. There would be a material impact on reported numbers in the Balance Sheet and Income Statement which will impact the leverage ratios.The following discussions shall be taken into consideration

A lease accounting would require a lessee to recognise assets and liabilities for most leases over 12 months and may improve the quality of Financial Reporting of an entity.

If the Capitalisation of Lease is done, the total equity will decrease resulting from decreasing net income and it would impact the Financial Ratios such as Debt to Equity Ratio, Debt to Assets Ratio, Return on Asset and Return on Equity rations will change.

The two important performance tools are Return on Assets and Return on Equity which assess the ability of the company to generate the income as compared to expenses.

The research has shown a comparison between positive and negative income sub-group. The companies in positive income group have higher increase in D/E Ratio as compared to negative income sub group.

The comparing results shown in this study document effect of lease capitalisation on Financial Statements and Financial Ratios. It was also found that these findings are only useful for the Australian Industries, financial statement users who invest in Australian companies.

The capitalization of operating leases requires the estimation of the present value of the operating lease (or unrecorded lease assets/liabilities).

The following assumptions are made for this research :

1. An interest rate of 10 % is used to proxy for the average incremental borrowing rate for the portfolio of operating leases for each firm

2. It is assumed that all cash flows occurred at year-end and assets are depreciated using the straight-line method of depreciation, whereas the interest payments are computed using effective interest method.

3. It would be presumed that a uniform15 years of remaining lease life is present.

4. A standard of 75% asset to liability ration is used for all firms

5. Corporate Tax is taken as 30%.

Conclusion : The above was the whole gist of the nature and scope of this issue of Lease Capitalisation

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