Current accounting for leases requires that certain leases be capitalized. For c

Question

Current accounting for leases requires that certain leases be capitalized. For capital leases, an asset and the associated liability are recorded. Whether or not the lease is capitalized, the cash flows are the same. The rental payments are set by contract and are paid over time at equally spaced intervals. Required:a.If one of the objectives of financial reporting is to enable investors, creditors and other users to project future cash flows, what difference does it make whether we report the lease as a liability or simply describe its terms in foot-notes?b.The efficient market hypothesis states that all available information is impounded in security prices. In an efficient capital market, would it make a difference whether the lease is reported as a liability or simply described in foot-notes? Explain.c. When there are debt covenants that restrict a company`s debt-to-equity ratio and when debt levels rise relatively to equity, management may be motivated to structure leasing agreements so that they are not recorded as capital capital leases. Discuss this motivation in terms of agency theory.

Explanation / Answer

Part A)

The lease obligation should be reported as a liability in the financial statements. Recording a lease obligation as a part of foot-notes may not provide the investors and other stakeholders with the correct information on the actual liabilities and financial position of the company. Since, the company is required to settle these obligations as and when due, it is essential to report them in the relevant sections of the balance sheet.

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Part B)

The amount to be reported on the liability side of the balance sheet with respect to lease obligation is the present value of all the lease payments. If such value is reported as a foot-note, it might be treated as an estimate and not an actual liability. However, since, the information on such an obligation will be known to the investors (even though as an estimate), the security prices will be considered to have factored in the effect of such a disclosure as per efficient market hypothesis. It is so because, efficient market hypothesis states that the impact of any information will have an immediate effect on the stock prices.

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Part C)

The basic objective of the company (here, agent) behind restructuring lease agreements would be to give a representation to the shareholders (here, principals) that there interests are protected as debt is maintained at an appropriate level in proportion to the equity. Inclusion of more debt in the capital structure would increase the financial risk of the company (in the form of higher fixed interest obligation) which may deter further or withdrawal of existing investment in the company.

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