The IMF's Statistical Systems in Context of Revision of the United Nations' A System of National Accounts
Chapter

25 Recording of Financial and Operational Leases and of Income on Zero- and Low-Coupon Bonds

Author(s):
Vicente Galbis
Published Date:
September 1991
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Balance of Payments Division, IMF Bureau of Statistics

In Chapter 3 of this volume, attention was drawn to the requirement that ownership of the factors of production and of goods and services is essential for both the allocation of the income accruing from the application of these factors and the identification of the various stages of the production and consumption process. In that paper, the nature of ownership was defined as “the capacity that it provides to the owner to determine the disposition of an asset”; further, it was suggested that “only the owners control whether assets are employed or remain idle, whether assets are passed to another, and whether assets are consumed or destroyed” (page 28). In addition, it was suggested that “the existence of such control usually exposes the owners to the risk of changes in the price of their assets and, in general, to regulatory strictures and other economic forces. . . . [and that] without such exposure, the intervention of governments in the market could do little to alter economic behavior” (page 28).

The paper suggested that the “ownership concept” be broadened for financial leases and that, with respect to the recording of income on zero-and low-coupon bonds, the accrual method should be adopted, which would result in interest being matched to the life of the debt and in the capital account reflecting the increasing debt associated with accumulating interest.

I. Exceptions to the Change-of-Ownership Principle for Financial Leases

In Chapter 3 it was also noted that, in the current (1977) edition of the IMF's Balance of Payments Manual (BPM), the ownership concept was broadened to account for financial leases, which in the early 1970s had become attractive because of the tax savings that could be obtained by that means of financing both domestic and international transactions.

At that time a broadening of the ownership concept was considered to be justified because financial leases have many of the hallmarks of a change of ownership, by passing control of an asset to the user while maintaining legal title to the asset on the part of the financing entity. Following publication of the 1977 edition of the BPM, other international organizations followed the Fund's lead; the European Community, the Organization for Economic Cooperation and Development (OECD), and the International Accounting Standards Committee (IASC)1 have all adopted the broader concept, although small differences between the three definitions of financial leases still exist.

In the BPM, financial leasing is defined as lease arrangements that provide for the recovery of all, or substantially all, of the cost of the goods, together with carrying charges. As a rule of thumb, a lease arrangement expected to cover at least three-fourths of the cost of the goods, together with the carrying charges, is to be taken as presumptive evidence that a change in ownership is intended. This BPM definition differs from the corresponding OECD definition, which calls for the arrangement to cover all of the cost of the goods, together with carrying charges. The IASC stops short of specifying a precise percentage share and defines a financial lease as “a lease that transfers substantially all the risks and rewards incident to ownership of an asset [while] title may or may not eventually be transferred” (IAS 17).

For lessees, IAS 17 (page 4) suggests that “transactions and other events ought to be accounted for and presented in accordance with their substance and financial reality and not merely with legal form.” Thus,

While the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. If such lease transactions are not reflected in the lessee's balance sheet, the economic resources and the level of obligations of an enterprise are understated, thereby distorting financial ratios. It is, therefore, appropriate that a finance lease be recorded in the lessee's balance sheet both as an asset and as an obligation to pay future rentals.

Similarly, for lessors, “an asset held under a finance lease should be recorded in the balance sheet not as property, plant, and equipment, but as a receivable, at an amount equal to the net investment in the lease” (IAS 17, page 13).

Unlike the BPM, however, IAS 17 does not indicate in terms of a percentage how much of the risk and rewards from ownership of an asset must be transferred by a lease agreement in order for that agreement to become a financial lease agreement. Nevertheless, equipment obtained from abroad under a financial lease is reflected in an increase in the acquiring economy's external debt, which is reduced at such time as that economy makes its lease payments. In contrast, under an operational lease (a lease other than a financial lease) an economy's external debt would not be affected by its acquisition of equipment.

The BPM recommends that the basic nature of these transactions—that is, the transfer of the economic risk from the lessor to the lessee—be given precedence over their legal form. At the time the possession of the equipment passes from the lessor to the lessee, a change of ownership of the equipment from the lessor to the lessee is imputed, and the full equivalent of the market value of the equipment (not the cumulative total of the expected lease payments) is recorded as merchandise, with an offsetting entry made in the capital account to record the imputed credit received by the nominal owner. Thereafter, the so-called lease payments to the actual legal owner are construed as investment income payments and repayment of the financial obligation that was in effect created when possession of the equipment passed from the lessor to the lessee.

Unlike the BPM, the United Nations' A System of National Accounts (SNA) does not refer to such an arrangement and, therefore, does not distinguish between financial and other lease arrangements. In the SNA, lease arrangements refer to the service provided by the owner in leasing his equipment to the enterprise that operates it. Because there is no change of ownership, the market value of the equipment is not recorded in the merchandise and capital accounts, and the lease payment is recorded in the services account.

Because national compilers appeared to be in favor of the methodology recommended in the BPM, that methodology was supported by the Expert Group on External Sector Transactions in March-April 1987 for the purpose of achieving the harmonization of the recording of financial leasing transactions in the BPM and the SNA.

The expert group agreed, with regard to financial leasing, that “guidelines for both the balance of payments and the national accounts should refer to the same cut-off point in determining what percent of the cost of a good, together with the carrying charges, must be recovered by an arrangement to qualify it as a financial lease.” The group, furthermore, agreed “that the cut-off point [between financial and other leases] should be less than 100 percent and should be considered in light of any current developments in financial accounting.”

Subsequently, national balance of payments compilers meeting in November 1987 in Paris concluded that “an international standard for distinguishing between financial and operational leases is needed. Participants generally were looking for guidance from the International Accounting Standards Committee, and suggested that the definition used for balance of payments statistics should be the same as that for national accounts statistics.”

In addition, those compilers “considered that until such guidance was forthcoming, the 75 percent cut-off referred to in the BPM should continue to apply in distinguishing between financial and operational leases for international transactions [and] agreed that arrangements similar to financial leases should be brought under the ambit for financial leases.”

II. The Time of Recording for Income

The currently recommended rule of thumb for recording interest in the national accounts is on a due-for-payment basis. This rule, however, can produce some anomalous entries in the balance of payments and reconciliation accounts of an economy. Consider the following example of a bond issued on day 1 of year 1, by economy A to economy B. The face value of the bond is 100 units, bearing annual interest coupons worth 12 units. The passage of time between coupon dates will result in economy B holding an additional asset, accrued interest. Such an asset must be recognized, but no flow can be recorded to explain its emergence because the income, which gives rise to the asset, cannot be recorded until the coupon date. The reconciliation accounts must, therefore, show an unrealized valuation change.

Further to the above example, 11 months after issue economy B sells the bond to economy C. Economy C sells the bond to economy D the day after the coupon date (day 1 of year 2). The balance of payments statements in Table 1 summarize these transactions. The current rule of thumb, together with the trading in the bond, require, among others, the following entries: the recording of an unrealized capital gain in the balance sheet for economy B to be realized in the balance of payments accounts at sale; no income to be recorded for economy B despite the provision of capital; for economy C, a large income entry to be recorded, relative to the value of the asset and the holding period; the reconciliation accounts for economy C will also show a large unrealized capital loss over the short period for which the bond is held.

Table 1.Recording Interest on a Due-for-Payments Basis
Year 1Year 2
EconomyCreditDebitCreditDebit
Economy A
Interest paid12
Bonds issued100
Foreign currency balances10012
Economy B
Bonds purchased100
Bonds sold100
Accrued interest asset11
Foreign currency balances11
Economy C
Interest received12
Bonds purchased100
Bonds sold100
Accrued interest asset11
Foreign currency balances111112
Economy D
Bonds purchased100
Foreign currency balances100
Note: In this example, on day 1 of year 1 economy A issues to economy B a bond with face value of 100 units bearing annual interest coupons worth 12 units; 11 months after issue economy B sells the bond to economy C; economy C sells the bond to economy D the day after the coupon date (day 1 of year 2).
Note: In this example, on day 1 of year 1 economy A issues to economy B a bond with face value of 100 units bearing annual interest coupons worth 12 units; 11 months after issue economy B sells the bond to economy C; economy C sells the bond to economy D the day after the coupon date (day 1 of year 2).

The adoption of accrual accounting for interest income would see the recording of income, both payable and receivable, commensurate with the provision of capital. Thus the increasing value of the asset-accrued interest—held by economy B would be recorded as a flow in the capital account and would be matched by income receivable in the current account. Economy C would record interest income only in proportion to the period for which it held the asset, and it would be measured as the difference between the amount paid for the accrued-income asset and the amount received, which in this example is the coupon payment of 12 units less the purchase price of 11 units. No unrealized valuation changes are necessary for either economy B or C. Economy D would also record interest income, reflecting its provision of capital for year 2. The balance of payments accounts in Table 2 present the entries appropriate under accrual accounting.

Table 2.Recording Interest on an Accrual Basis
Year 1Year 2
EconomyCreditDebitCreditDebit
Economy A
Interest payable1212
Bonds issued100
Accrued interest liability12
Foreign currency balances10012
Economy B
Interest receivable11
Bonds purchased100
Bonds sold100
Foreign currency balances11
Economy C
Interest receivable1
Bonds purchased100
Bonds sold100
Accrued interest asset1212
Foreign currency balances111112
Economy D
Interest receivable12
Bonds purchased100
Accrued interest asset12
Foreign currency balances100
Note: The terms of the transactions are the same as noted in Table 1.
Note: The terms of the transactions are the same as noted in Table 1.

Adopting the accrual method of accounting for income not only avoids the need for the valuation changes, but matches the cost of capital with the provision of the capital. It results in a more meaningful analysis of debt servicing in the short term and avoids the possible understatement of current income and, therefore, of current account surpluses that, under a due-for-payment basis, could be achieved through judicious acquisition and disposal policies timed to avoid coupon dates.

A particular distortion arises in the case of deep-discount bonds. These are issued with zero or low coupon rates and at a discount which, on bonds with maturities of ten years or longer, can be 70 percent or more of the face value of the bond. The due-for-payment basis requires reporting this interest at maturity.

An argument for recording interest on a due-for-payment basis is that some instruments are not negotiable and the income cannot be realized before the coupon date. This is analogous to recording wages only on payday, or goods transactions according to payment terms. Another argument is that data are only available for contract terms. This is unlikely given modern commercial accounting standards and practices.

Adopting the accrual method would result in interest being matched to the life of the debt, while the capital account would reflect the increasing debt associated with accumulating interest. Stock data, incorporating the accrued interest (and dissected by maturity) would better reflect the liability of the debtor and the causes of that liability. Any asymmetry in current account measures of interest paid or received because of the inability of economies to report interest earned or accrued would be matched, and possibly be identifiable, by the asymmetry in the interest liability or asset reflected in the capital account.

Where royalty and other property income payments are also payable at discrete points in time and such payments represent the use of an intangible asset over a number of time periods, again the accrual basis, rather than the due-for-payment basis, would result in a proper matching of the use of an asset and the cost of that use.

In deliberating on these issues, the Expert Group on External Sector Transactions agreed that “the due-for-payments, as opposed to the full accrual, recording of income should be maintained [but felt that] an exception to the due-for-payment recording be made for zero-coupon bonds.”

International Accounting Standard, Accounting for Leases (IAS 17), International Accounting Standards Committee, September 1982.

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