Capital lease accounting is one of the area where IFRS differs from U.S. GAAP. The broader difference between GAAP and IFRS is that IFRS classification criteria are less detailed that GAAP. US GAAP specifies the four criteria to identify a lease as a capital lease. If any one of the criteria is met the lease should be treated as capital lease.
1) The lease transfers ownership of the property to the lessee.
2) The lease contains a bargain purchase option.
3) The lease term is 75 % or more of the useful life of the property.
4) The present value of the lease payments equals or exceeds 90% of the Fair Market Value of the property.
IFRS leaves more to the judgment of the manager, stating that capital lease accounting should be used if substantially all the risks and rewards incidental to ownership have been transferred from the lessor to the lessee whereas US GAAP criteria are more detailed as it mentions of exact percentages. This difference is one of many where IFRS relies on judgment (principle based) and U.S. GAAP relies on rules (rule based).
Companies can practice off-balance-sheet financing by shaping lease contracts so that none of the four criteria are met, which, in turn, allows them to account for leases as operating leases that may in economic substance be capital leases. Such treatment keeps the liability related with the lease off the balance sheet.
Though government is trying to improve the accounting standards post Enron incident, US companies are still allowed to keep off their balance sheets billions of dollars of lease obligations which are same as the obligations of bank loans or other borrowings. The practice is followed in all type of industries and the scale of these off balance sheet obligations is very huge. For e.g.:
US Airways Group Inc.: which recently filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn’t include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.
Drugstore chain Walgreen co.: shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.
For the companies in the Standard & Poor’s 500-stock index, off-balance-sheet operating-lease commitments, as revealed in the footnotes to their financial statements, total $482 billion.
A company’s financial health is measured by its debt levels. This treatment of leases in an unclear way can complicate the interpretation of any financial ratio (e.g., return on assets or capital structure leverage) evaluations across the two companies; and the different accounting handling for many leases means that a big portion of business financing rests in the shadows. In spite of all the stringent laws and regulations set up since Enron collapse, officials have left lease accounting principally untouched.
Reference: