Accounting and Disclosure under IAS 17 by Lessee - Essay Example

IAS 17 Leases In order to recognize the income in respect of lease transactions, an appropriate method of accounting is necessary so that the lessorand lessee can disclose the treatment of leased assets properly in their books. The necessity for arriving at a proper accounting method stems from two considerations. First, if lease rentals are recognized as per the lease agreement, there is likely to be a distortion in the profit and loss account. Secondly if the lessee does not disclose the leased assets in his balance sheet there are chances of distortions of the financial status of the lessee. Recognizing this need for a proper accounting of lease financing transactions the International Accounting Standards Board (IASB) has issued IAS 17 in respect of the leasing and financial instruments in the year 1982. It is observed that in spite of the changes that these standards propose to bring about the companies are still able to resort to Off Balance Sheet Financing which vitiates the objectives of the standards introduced by IASB. This paper presents a detailed review of the effectiveness of IAS 17 in achieving its objectives and comments on the new standards proposed to be issued in this respect. IAS 17Framework For assessing the effectiveness of IAS 17 it is important to understand the nature of accounting for finance and operating leases by a lessee and disclosures in their financial statements. Accounting treatment for finance lease and operating lease by the lessee is prescribed by IAS 17. Accounting and Disclosure under IAS 17 by Lessee "A finance lease should be reflected in the balance sheet of a lessee by recording an asset and a liability at amounts equal at the inception of the lease to the fair value of the leased asset net of grants and tax credits receivable by the lessor; if lower at the present value of the minimum lease payments." (Khan, 2007) The lessee should be appropriated between the finance charge and the reduction of the outstanding liability. A finance lease involves the accounting of the depreciation charge for the leased asset as well as the financing charge for the relevant accounting period. In respect of the operating lease the rental expenses for the accounting period shall be charged to income. The charge to income should be recognized on a systematic basis which represents the time pattern of the benefits for the user. The amount of the assets that are subject to finance lease should be disclosed at the values as at the balance sheet date. Liabilities relating to the leased asset should be disclosed separately from other liabilities. The liabilities are to be differentiated between the current and long term portions. The lessee's commitment for minimum lease payments under finance lease or non-cancellable operating lease having tenure of more than a year should be disclosed in summary form. This disclosure should specify the amounts and periods in which payments would become due. The accounting statements should also specifically disclose any significant financing restrictions or other conditions attached to the leases. Accounting and Disclosure under IAS 17 by Lessor An asset held by the lessor under finance lease should not be disclosed in the balance sheet as property, plant and equipment. Alternatively the asset item should be shown as receivable at value that equals the net investment in the lease. The recognition of finance income on the lease should be calculated using any specific pattern that reflects a constant periodic rate of return. This rate of return should be based on either the net investment outstanding or the net cash investment outstanding in respect of the particular lease under consideration. There is no specific method prescribed for estimating the value or the net return. Rental income on the lease should be recognized on a straight line basis over the term of the lease unless the lessor finds any other systematic basis that is more representative of the time pattern contained in the lease contract concerning the earning process. The main purpose of the proposed changes in IAS 17 is to prescribe the companies the treatment of land and buildings. The change requires the companies to treat the land and building as separate leases. Now the business entities have to arrive at the rental values of land and buildings separately. Similarly the type of lease has to be determined by them and should be accounted for. Comparison of IAS 17 with FASB Statement No 13 It is also necessary to compare the accounting and disclosure of leasing transactions prescribed by FASB Statement no.13 "Accounting for Leases". Statement of Financial Accounting Standards 13 which deals exclusively with the leasing transactions under US GAAP (SFAS 13) requires that there must necessarily be a distinction between both operating and capital lease. For making this distinction explicit the standard has specified four specific criteria like transfer of ownership at the end of the lease, bargain price options, extension of lease for 75 percent of the asset's life and present value of lease payments. The purpose for specifying such criteria is to ensure that the lease transactions are characterized with their natural intentions and classified as capital or lease transaction depending upon the true nature of such transactions... If a contract satisfies any of the four criteria, it must be recognized as a capital lease in the financial statements. While comparing IAS 17 and FASB Statement No 13 a number of similarities can be noticed. ". "Both standards define leases similarly, and both require that a leased item be recognized as an asset on the lessee's balance sheet for leases under which substantially all the risks and rewards incident to ownership of the leased asset are transferred to the lessee (that is, for leases classified as capital leases (Statement 13) or finance leases (IAS 17))." (US Securities and Exchange Commission, 2000) The lessee need not recognize the asset if the asset is classified as an operating lease. However the implementation guidance provided by IAS 17 for the determination of lease classification is less detailed as compared to the corresponding statement No. 13. For instance there are specific criteria prescribed by the FASB statement which need to be met for determining whether a leased asset item should be classified, whereas IAS 17 relies on the assessment and judgment of the management to determine the 'substance' of the lease transaction. It is a complex process to predict how often the leased items that would be eligible to be capitalized under Statement 13 would be treated under IAS 17 for capitalization purposes. The "bright line" approach being followed by Statement 13 removes to a large extent the subjective assessment by the management of the substance of the lease transaction to decide whether it is a capital lease or an operating lease. However the approach under Statement 13 is open for the lease transactions to be structured either to meet or to avoid the meeting of the criteria specified under the statement. On the other hand, the approach by IAS 17 provides more room for subjective judgments in deciding the substance of the lease transaction. Therefore in the absence of specific criteria it is difficult to determine whether all the entities apply the same criteria in determining the substance of the lease transactions for accounting and disclosure under IAS 17. Because of the element of judgment involved in the classification of the lease transaction under IAS 17, the approach under IAS 17 may allow the recognition in the balance sheet of a lease which in substance in capital lease but which does not meet the criteria specified under Statement 13. Irrespective of the fact that whether the item is recognized or unrecognized would obviously create problems in comparing the financial statements by the users since they may not represent the assets and liabilities in the same way. This problem will become more prominent in cases where the investors look at the financial statements of different entities for evaluating the capital structure by calculating the financial ratios and measuring the relative performance of the entities. Effectiveness of IAS 17 With the changes in International Accounting Standard 17, which deals with the leasing transactions, if in a leasing transaction all or substantially all risks and rewards incidental to the ownership is transferred to the lessee by the covenants of the lease deed, then the lease is to be treated as a capital item and should be included in the balance sheet and reported as capital item. Thus IAS 17 has made it difficult for the companies to execute lease agreements with minimum requirements to be used to cover leasing as "off balance sheet financing" However the provision of such specification has not resulted in the expected way to make the firms show the true nature of the individual transactions. In many cases, the firms have taken advantage of these provisions and have made the lease contracts in such a way to avoid them being caught in any of these four criteria. "Because precise rules were established, companies carefully structured lease contracts to qualify as operating leases. As a result, the explicit rule allows the off-balance-sheet financing to continue, and provides justification for the treatment." (Shortridge & Myring, 2004) Recent Proposals on Modifications to IAS 17 In March 2009, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have published the discussion paper Leases: Preliminary View and the comment period for representing the viewpoints ended in July 2009. The issue of the discussion paper was considered necessary in the light of the criticisms leveled against IAS 17 and Statement No 13 as they are more reliant on subjective judgments and are rigid in defining the thresholds. It is believed that such excessive reliance on subjective judgments has led to economically similar transactions being accounted for by the entities in different ways and it also allowed the entities to structure the leasing transactions to achieve any desired accounting effect in the financial statements prepared and presented by them. The debates by the Boards considered the scope of lease accounting by the lessor and the lessee. Although initially the Boards agreed that both the lessor and lessee accounting need to be considered, the Boards later on revised their stand to the effect that while there will be views expressed on the lessee accounting, the lessor accounting would be left to remain in status quo. Therefore there have been no preliminary views expressed on the lessor accounting and disclosure of lease transactions. First the Boards expressed the view that the scope of the proposed model should be based on the scope of the existing leasing standards, mainly because the entities have become familiar with these standards. In respect of the lessee accounting of the lease transactions the boards expressed the views that on the overall model "Recognize a single right-of-use asset and a single liability for the obligation to pay rentals." (ISA Plus, 2009) In the matter of measuring the right-of-use asset, the preliminary view of IAS states "initially measure at cost, which would equal "the present value of the lease payments discounted using the lessee's incremental borrowing rate. Subsequently measure the asset on an amortised cost basis over (1) the shorter of the lease term or the economic life or (2) if the lessee is expected to obtain title, the economic life." (ISA Plus, 2009) In respect of measuring the obligation to pay rentals, the Board is of the view that the initial measurement should follow the "the present value of the lease payments discounted using the lessee's incremental borrowing rate. Subsequently measure by using an amortised cost based approach in which interest is accrued on the outstanding obligation to pay rentals." (ISA Plus, 2009) The Board has expressed similar preliminary views on measurement or reassessment of the incremental borrowing rate, measurement of the changes in estimated cash flows, determination of lease term and reassessment of lease term which have been made to rely mostly on the subjective assessment of the management. The scope as expressed in the preliminary views provide for the exclusion for either leases of non-core assets or short-term leases. However all leases will give rise to some form of assets and liabilities. Therefore such exclusion does not provide for any conceptual justification to exclude these classes of leases from the scope of the proposed new standards. Such exclusions may also provide for complexities in treatment for accounting, disclosure and comparability and will enhance the opportunities for entities structuring the lease transactions (ISAB, 2009). The approach taken by the proposed model reflects the economic substance of a lease transaction and therefore the disclosure may be able to provide more relevant information than the information that are being currently provided to the users. It is important that the proposed model retains the distinction between capital and operating leases as such classification represents the genuine economic differences between different types of leases (ISAB, 2009). The recognition of a single right of use to an asset or liability may take away the clarity in disclosure and is likely to result in complexities in comparison. However there is an opposite view to this in that the existing different components approach is too complex and expensive to collect and provide the necessary information. The proposed single asset and single liability concept will reflect the inter-relatedness of the lease components such as options, contingent rentals and the non-callable contractual period which are more meaningful in analyzing the nature and scope of lease transactions. The board's tentative decision to measure the obligation of the lessee on rental payments using the present value of the lease payments adds credibility to the transaction. However the discounting rate to be used to arrive at the present value is debatable as there is the option of using the lessees' incremental borrowing rate or the interest rate implicitly attached to the lease transaction. Similarly the view of the board to measure the lessee's right of use asset at cost appears to have validity and relevance as it is consistent with the measurement of other non-financial assets. The view of the board to adopt an amortized cost-based approach instead of a linked approach to subsequently measure the obligation to pay rentals and the right to use asset can be considered as relevant and practical as such an approach is consistent with the current guide lines for non-derivative financial liabilities and non-financial assets and the approach is likely to increase comparability among reporting entities. However the linked approach has its own advantage in that the linked approach reflects the economics of most of the lease contracts as the costs are evenly distributed over the lease term. In addition in the linked approach the link between the right to use asset and the obligation to pay rentals are linked throughout the term of the lease. The views expressed by the board on the option to adopt fair value for measuring the obligations to pay rentals, reassessment of interest rates to revise the obligation to pay rentals by the lessee to reflect changes in the incremental borrowing rates, providing guidance for accounting the obligations to pay rentals, and the option to describe decreases in the right of use asset to be treated as amortization or depreciation rather than as rental expense are considered adding to the subjective elements to the scope of the revision in the standard. Reference List ISAB, 2009. Comment Letter Summary. [Online] Available at: http://www.iasb.org/NR/rdonlyres/66BF0DCB-2A78-4F30-A6B8-DC5E018C066D/0/Leases0909b06Aobs.pdf. [Accessed 10 December 2009]. ISAPlus, 2009. Boards Issue Preliminary Views on Lease Accounting. [Online] Available at: http://www.iasplus.com/iasplus/0904leasingdp.pdf. [Accessed 10 December 2009]. Khan, 2007. Financial Services. New Delhi: Tata Mc-Graw Hill. Shortridge, R.T. & Myring, M., 2004. Defining Principles based Stanards. [Online] Available at: http://www.nysscpa.org/cpajournal/2004/804/essentials/p34.htm [Accessed 10 December 2009]. USSecuritiesandExchangeCommission, 2000. International Accounting Standards. [Online] Available at: http://www.sec.gov/rules/concept/34-42430.htm [Accessed 10 December 2009]. Read More