The principal justification for using the FIFO method for inventory valuation is
that under FIFO the cost of goods sold on the income statement is valued more ac-
curately and FIFO is thought to better parallel the physical flow of goods. As a gen-
eral rule, there is a better matching of the costs incurred to produce the inventory with
its revenues. Additionally, the balance sheet will be presented more accurately, be-
cause the inventory stated on the balance sheet will be valued at the most recent
prices. The FIFO method is permitted in all countries and is accepted under the IAS
benchmark approach.
(d) Leases. Leasing has become quite popular in recent years due to the high de-
gree of financial and tax flexibility it gives both the lessor and the lessee. Leasing
often affords the parties tax advantages not available in the purchase of fixed assets.
In contrast to an outright purchase, the rights and risks in a leasing transaction can
be assumed by either party in a number of different combinations; leases essentially
allow a company to “buy” an asset for a specified period of time. Depending on the
specifics of the leasing contract, differences arise among the countries’ accounting
rules as to how such transactions should be accounted for. The basic accounting
issue regarding leases is whether a leased item can or should be capitalized as an
asset as if owned or whether the lease payments should be treated as periodic rent
expense.
When a company (lessee) leases an item from another entity (the lessor), the trans-
action could be viewed as an acquisition of an asset if the lease term is the majority
of the useful life of the item or if the price paid is significant when compared with
the fair market value of the item. When these criteria, among others, are met, some
would argue that substantially all the risks and benefits of ownership of the leased
property have been transferred from the lessor to the lessee, thus calling for capital
lease treatment. Those who view a lease in this manner would argue that the lease
contract ought to be accounted for as a purchase of an asset on the lessee’s books.
Generally, the same people would also argue that the lessor should treat the lease as
the sale of the underlying asset. Under a capital lease, the lease is accounted for as if
the lessee borrowed money and acquired the asset and the lease payments represent
payments of principal and interest on the borrowing.
Many countries’ principles, including those in Australia, Canada, the Netherlands,
the United Kingdom, and the United States, require capital lease treatment if certain
criteria are met. Similarly, IAS 17, “Accounting for Leases,” requires leases to be
capitalized if certain criteria are met.
The alternative method is to expense the lease payments as they occur, which is
referred to as an operating lease treatment. As shown in Exhibit 12.2, there are some
countries, such as Japan, where standards permit all leases to be accounted for as op-
erating leases, provided there is footnote disclosure of capital leases. Under this
method, the leased property remains an asset on the lessor’s books. The rationale be-
hind this treatment is that the asset has not legally changed hands.
Depending on whether leases are on- or off- balance sheet, their treatment can be
quite controversial as it may have a significant impact on certain debt covenants,
leverage, interest coverage and other financial data and ratios. There continues to be
concern that many operating leases contain non-cancelable obligations that are not
being given accounting recognition as liabilities. Some argue that all non-cancelable
lease commitments should be recognized as liabilities to better reflect the substance
of the rights and obligations leases embody. While sophisticated analysts may ar-
12.6 FINANCIAL STATEMENT EFFECTS 12 • 15