Accounting

Question 3.34

(a) Why would companies have preferred to treat the leases as operating leases (if there is a finance lease then the assets and liabilities associated with leased asset are not shown on the statement of financial position) rather than finance leases (if the lease were a finance lease then the liabilities and assets associated with the lease would be shown on the statement of financial position)?

Answer: If companies treat the leases as operating leases they would not have to show lease as a liability, as a result the total debt would be lower (Deegan 2012). This could be a critical factor while entering into a debt contract which might restrict the amount of debt they are permitted to have, therefore companies would have treated the leases as operating lease rather than finance leases. Moreover managers tends o classify leases as operating instead of finance leases because the total cost of finance lease in the early stage will exceed in comparison to operating lease and some contracts may include accounting profits such as profit sharing agreements within management.

(b) Explain why the change in the accounting standard for leasing might cause organisations to breach covenants included within debt contracts.

Answer: A change in the accounting standard for leasing might cause organisations to breach covenants included within debt contracts because the new accounting standard might require bringing more debt in the balance sheet and this might trigger the organization to breach covenants for instant debt to asset restriction.

(c) What is the difference between debt covenants that rely upon ‘floating GAAP’ and those relying on ‘fixed GAAP’, and which provides less risk to the borrower?

Answer: In ‘floating GAAP’ whenever a debt is calculated it is calculated on the basis of the accounting rules in place, when each time the covenant is calculated and on the other hand when a debt is calculated that relies on ‘fixed GAAP’, will be calculated...