Accounting Theory and Contemporary Issues - Assignment Example

Question one

Under the existing standard IAS 17 (AASB 117) Leases - what are operating and what are finance leases? Explain the concepts briefly with reference to lessees only, rather than providing all the technical details.

Response to Question one

The finance lease is the lease in which all the lease rewards and risks are easily transferred to the incidental ownership. While an operating lease does not substantially transfer all the rewards incidental and risks to ownership (Rankin 2012). A lease depends on the transaction substance and not the form of the contract whether it is an operating lease or a finance lease. These leases in the financial statements of lessees occur as follows:

The finance leases

The initial recognition

When the lease term commences, lessees have to record their finance leases as liabilities and assets in their financial statements indicating their financial position in amounts similar to the leased property fair value, and in case it is lower, the minimum lease payments present value is determined during the lease inception. To calculate the present value of the minimum lease of the amounts payable, the discount rate is the interest rate contained within the lease if the interest is easy to determine. If it cannot, the borrowing lessee’s incremental rate is used. The lessee direct costs are added to the amount, which has to be recorded as assets.

Events and other transactions ought to be accounted for and presented according to their financial reality and substance and not as simple legal forms (Rankin 2012). Despite the lease agreement legal form establishing that the lessee should not acquire legal title to the leased equipment, in cases of finance leases, the financial realities are evident. The lessee gets economic benefits for using the leased property for the main part of the economic life of the asset due to entering into the obligation to paying an amount approximating to that right, at the lease’s inception, the related finance charge and the fair value of such an asset.

The direct costs initially incurred related to specific leasing activities like securing leasing arrangements and negotiating tend to be recognized by the lessee as assets.

Subsequent measurement

Minimum lease payments ought to be divided between the reduction of the outstanding liabilities and the finance charge. The finance charge has to be allocated periodically over the period of lease to provide a constant periodic interest rate over the remaining liability balance period. Contingent rents will be expenses charged in the period upon which they would be incurred.

The finance lease results in a rise in expenses of depreciation for assets that could be depreciated and the finance expense to every accounting period. The policy for depreciation on such assets will be consistent with that of owned depreciable assets calculated accordingly to AASB 138 Intangible Assets and AASB 116 Property, Plant, and Equipment (Rankin 2012). If it is uncertain, the lessee shall obtain ownership of the property once the lease term is over, the assets is fully depreciated over its useful life and in the short term lease period.

Disclosures

Disclosures involve:

1. Reconciliation between future minimum lease payments total and their present value at the end of each reporting period. The entity is also required to disclose at every reporting end the total future minimum payments on the lease and their present value in the periods below:

a. Not later than a year

b. Later than a year but not later than 5 years and

c. Later than 5 years

2. The total minimum sublease payments of the future expected to be received under non-cancellable sublease at every end of reporting period

3. The contingent rents should be recognized as expenses

Operating leases

All the lease payments made under the operating lease should be recognized as expenses on a straight-line basis over the lease period except a different systematic basis represents more of the time pattern of the benefits the user gets (Rankin 2012).

For the operating leases, the payments on lease excluding maintenance, insurance and other costs of service are identified as expenses on the straight-line basis excluding a different systematic basis seems more a representative of the pattern in the period the benefits are obtained by the user, even when those payments are not of that foundation.

Disclosures

Lessees in accordance to meeting the AASB7 requirements shall make disclosures for operating leases on:

1. Total future minimum lease under operating leases that are non-cancellable in the following periods:

a. Not later than a year

b. Later than a year but not later than 5 years and

c. Later than 5 years

2. The total minimum sublease payments of the future expected to be received under non-cancellable sublease at every end of reporting period.

3. The general description of the leasing arrangement of the lessee that include explains the basis under which the determination for contingent rent payable is made among others.

Question two

What are the main differences between IAS 17 (AASB 117) and the new IFRS 16 (AASB 16) from the lessee perspective?

Response to Question two

The new standards are expected to commence on January 1, 2019, and the major implications on the Lessee accounting include:

Initial measurement and recognition

The lessee is required to recognize the lease initially as a liability for the requirement to make payments on the lease and have the right to use the asset measurable at the present value of the lease payments paid over the period of the term (Rankin 2012). The payment would include:

1. Fixed payments less any incentives received on the lease

2. Payment on variable lease depending on the rate or the index and at the commencement, measurable by the index

3. The expected payable amounts under residual value guarantees

4. Penalty payments for lease termination, whereby the lease term indicates the lessee expressing the desire to end the contract.

Therefore, the lessee is not required to have an estimate of future variable payments but rather at the period in which reporting is done, the right-of-use is remeasured and adjusted for variable payments in the future.

Subsequent measurement

To reduce liability and reflect interest to show the lease payments made, the lessees should accrete the lease liability. Following the AASB116/IAS 16 property, Plant and Equipment requirement, it stipulates on the right-to-use asset depreciation procedures. However, the use of straight-line basis on depreciation is likely to give higher expenses at the beginning periods of the lease (Rankin 2012). Therefore, upon the occurrence of certain events such as the change in a renting variable or lease term change should result in remeasuring lease liability.

Presentation

Lease liabilities and right-to-use assets should be disclosed distinctly in notes or presented separately from the rest of the liabilities and assets in the balance sheet. Interest expense and depreciation expense are not combined in the income statement. Subsequently and an entity such as the EBITDA and EBIT under the IFRS 16 will be different from those under the current standards due to the difference in presentation and measurement of lease related expenses. Principle payments as it regards lease liability have to be recorded on the financing activities in the cash flow statement.

Question three

What is meant by ‘off balance sheet liabilities’ in the article?

Response to Question three

According to the article, “off-balance sheet liabilities” simply refers to when a company fails to include liabilities in its balance sheet. The behavior affects the company’s level of liability and debt, and it is an accounting term. Accordingly, the common forms of the off-balance liabilities arise from partnerships and operating leases. Over the years, operating leases have occasionally been used, although the new standards of accounting are projected to tighten and lose the behavior (Rankin 2012). The consequence is having greater amounts of liabilities while their balance sheet deceptively shows minimum liabilities.

A perfect example arises when a company leases or rents certain equipment and later purchases the property when the lease ends for a little amount of money or decide to buy the equipment immediately. Irrespective of the approach, the company will end up having the building or the equipment. The manner in which the company accounts for the purchase creates the difference. For the operating lease to occur, rather than the company recording the total amount of purchase immediately, the company only records rental expenses. When a purchase is outright, the company records the purchase price (liability) and the equipment (asset). Therefore, through using the operating lease, the company tends to record rental expenses, a significantly lower when compared to recording the entire buying price, hence a transparent balance sheet. Several of off-balance sheet liabilities result in financing, which is not sometimes required to be disclosed or sometimes having partial disclosures, providing insufficient data that could be used to comprehend the company’s total debt.

Question four

Why will the changes to lease accounting ‘not be popular with everyone’? In particular, why may the changes lead to ‘defaults on debt covenants’?

Response to Question four

The new standard will bring new accounting techniques. Leases thought to be capital leases because of their characteristic and terms for a long time have had the commitment or have a “debt” association with the lease recognized to the balance sheet (Rankin 2012). Therefore, these lease types would not greatly change in the new standard. In the past, the operating costs have not been recorded in the balance sheet as liabilities. However, this is to change as the right-to-use is to be recorded correspondingly with lease liability. Paying for the lease will result in liability reduction and the right-use amortization providing an expense in the income statement.

The reason why these changes may lead to ‘default in debt covenants’ is due to the longer periods that companies would require reviewing their legal agreement and debt covenants. The review is expected to assess the potential impact that would arise from these documents. The result is unintended outcome such as defaulting on debt payments as the surety credit, and the lending world will have new anticipation while expecting changes in the manner in which financials will look.

Question five

An alternative viewpoint to those taken into account by the IASB is that no separate standard is required on leases at all. What would the arguments be for this? Would you prefer no leasing standard, the existing standard (IAS17) or the new standard (IFRS 16)? Please explain your position.

Response to Question five

An alternative viewpoint to those taken into account by the IASB is that no separate standard is required on leases at all due to the implementation process and costs that would be incurred in maintaining different standards. I would prefer the new accounting standards since the benefits tend to outweigh the costs incurred in implementing and the losses that were incurred when the economy faced turmoil (Rankin 2012). The costs incurred include:

1. Depending on the conditions and terms of the leases, the portfolio size and the systems already in place to handle the leasing agreement and activities, the lessee is likely to incur implementation costs. The costs arising for example come from:

a. The requirement to establish the discount rate on every lease that has more than 12 months.

b. When they enter into leases with variable lease payments depending on the rate or variable index, there is the need to remeasure the liability arising from the lease based on the rate or index at the end of each reporting period.

c. The lessee would probably need to educate its staff hence incurring costs while updating their systems. In providing all the disclosures required by the standard, lessees should have information about the lease and an inventory showing the future lease payments on every lease, however, costs will not rise with this regard.

2. Lessees having less sophisticated equipment to track and handle leases are expected to incur large costs than the other lessees.

3. Vehicle and equipment lessors to enter into operating leases are projected to have more costs in upgrading their accounting systems.

It is expected that these proposals for the new accounting system to improve the quality if financial reporting through:

1. To the lessees, the liabilities and assets arising from the leasing agreement are sufficient. A more faithful representation of the lessee on their financial position by recognizing these liabilities and assets of more than 12 months is enhanced, together with greater transparency and enhanced disclosure will express the lessees leverage (Rankin 2012). To provide information as required by the IAS 17 about the lessee’s undiscounted payments of the future lease in the notes alone is:

a. Misleading to those who use financial statements to provide leverage.

b. Provides minimum information to others, which may not be accurate.

2. Presenting and recognizing lease expenses emerging from the several equipment leases differently from the ones arising from property leases would indicate a different economics of other property and equipment leases.

3. Equipment leasing agreement accounting differently from property leases as it regards the lessor would indicate that, generally speaking, an equipment lessor’s business model is different from the property lessor’s business model

Based on the costs and the benefits obtained about the new accounting standard, it is evident that benefits outweigh the costs, expenses, and risks that have been incurred for a long time (Rankin 2012). Therefore, I support the new accounting standards for its ability to promote transparency, accountability, and accurate reflection of information.

Reference

Rankin, M., Stanton, P., Ferlauto, K., (2012). Contemporary issues in accounting. Milton, Qld, John Wiley and Sons Australia, Ltd.