Accounting for Leases and Accounting for Provisions - Assignment Example

? 14th January Accounting for Leases and Accounting for Provisions Part (a) (i) At the start of a lease term, IAS-17 depicts that lessee should record the finance leases as liability as well as assets in the accounting books. In order to have the appropriate figure, the lessee is required to compare the fair value and the present value of the asset. The present value is arrived at after discounting the lease payments based on the interest rate that is associated with the lease payments. Similarly, in the lessee books of accounting the periodic lease payments should be apportioned between the reduction of the current liability and the finance charges. This is done so as to reduce the amount of interest that is paid by the lessee on the regular lease payments. Another significant aspects that lessee should consider is the depreciation of the assets leased. According to IAS-17, the depreciation of property held under lease should be similar to those assets that are owned. However, if it is uncertain that the lessee will own the property, the life of the property or the lease term whichever is lower is considered during the depreciation (Carpenter et al, 1994). One of the key aspects that characterize a lease is that the lessee purchases an asset from a lessor. However, instead of paying cash, it is deemed that the purchase is financed with a loan that is given by the lessor. In this regard, the lessees are supposed to include the loan interest on the lease payments thus decreasing the lease liability. This is computed as follows. Yearly lease payments-Interest expense (initial lease liability * interest rate) =Reduction of the lease liability (Dirsmith and Haskins, 1991). After computation of the lease liability, the lessee makes a journal entry as follows. Dr Interest Expense Account with the amount of interest expense calculated above Dr Lease Liability Account the difference Cr Cash Account amount paid Computing the value of the leased property It is imperative for lessees to determine the value of the asset that will be recorded in their books of account. This entails the amount of cash that the lessee would have paid in case he or she purchased the asset in cash. This is the current value of the minimum lease payments (MLP). To arrive at the minimum lease payments, two major interest rates are considered that include market rate and implicit rate whichever is lower. Part (a) (ii) Problems relating to the recognition and classification of leases in corporate financial statements Classification and recognition of leases in corporate financial statements is a major challenge that is faced by many organizations. This is based on the fact that different forms of leases are differently treated in the financial statements. One of the major problems is whether or not the rewards and risks associated with leases remain with the owners. Key rewards include capital gain as well as the right to sell property (Emby and Gibbins, 1988). On the other hand, risks involved are variations in the amount of returns, loss from idle assets in addition to obsolescence of the technology that is transferred from the lessor to the lessee. Transfer of rewards and risks to lessee The amount of risks and rewards that is transferred to the users is a major challenge that faces the accountants during the accounting treatments of leases. In this regard, it is fundamental for companies to highly recognize the concepts of the agreement between the lessors and the lessee even though the legal form of the agreement is vital. For example, a financial lease encompasses the transfer of all benefits and risks to the lessee (Gibbins and Mason, 1998). If there is no such transfer, then this becomes an operating lease. Similarly, the legal form of a lease may indicate that a company is exposed to few benefits and risks from the property leased but the substance condition of the agreement may indicate a very different scenario. This leaves the accountant with a major responsibility of determining the level of risks and benefits that the company will derive from the asset during the classification of the lease. Inadequate lease agreements Inadequate lease agreement is another problem that faces classification of leases in the corporate financial statements. For example, for a lease to be classified as a financial lease, it should portray various situations. First, by the end of lease term the ownership of the asset should be transferred to the lessee. Secondly, the assets should be used by the lessee without major modification since they are specialized in nature (Gibbins and Mason, 1998). Thirdly, the lessee has a chance of purchasing the property at a lower price as compared to the market value. Fourthly, the fair value of the asset is equal to the minimum lease payments. Based on the fact that some agreements may depict more convincing situation than others, it creates a challenge when classifying the leases. In this case, accountants should properly scrutinize the substance of the agreement for an effective classification. It is vital to note that the determination of risks that are retained by the lessor and the rewards that the user attains are also important aspect during the classification of leases. For instance, if the use of the property or changes in the asset market price renders the lessor to experience a risk, then such a lease is classified as an operating lease. In the same way, if the asset does not portray any risk, then such an agreement results to a finance lease. Changes of the lease agreements A lease is classified during its inception. This refers to the date when the parties to the contract becomes bound by the provisions of the agreement or the date of the agreement which comes earlier. A major problem that is faced by corporate in classifying the leases is due to the alteration that may be done on the leases terms (Gibbins et al, 1990). As a result of such alterations, a new lease is assumed to have been formed thus having an implication on the financial statements of a company. A good example of a problem that is faced by organizations is during the classification of land and building leases. This is due to the fact that the two assets should be treated differently. Additionally, allocation of minimum lease payment between the building and land is also a significant challenge. To mitigate the problem of land classification, IAS-17 made an amendment that subjected land to a general classification criterion that companies should emulate. Example of land and building lease Peter has entered into a land and a building lease where after 15 years he gets the title of the building. He entered into the contract on July 2007. During this time the value of the building was 18 million US dollars while the land was valued at 54 million US dollars. On June 2009, $2 million and $6 million annual rent was paid in arrear for building and land respectively. According to the agreement, the minimum lease term (MLT) is 30 years while after every six years the lease payments were reduced (Gibbins et al, 1990). In July 2008, NPV for building and land was $17 million and $40 million respectively. After 15 years, the buildings were written off when the interest rate was 7%. Based on the above example, there was no transfer of the land to Peter. This makes the land lease to be classified as an operating lease. On the other hand, after 15 years the bulking title was passed to Peter resulting to a finance lease. During the inception of the lease, a significant minimum lease payment was paid indicating that the building was reasonably owned by Peter. Part (b) (i) Provisions refer to the amount of funds that are set aside to cater for future event that can be unidentified or identified by an organization. In their operations, companies experiences events that can affect their gross profits as well as net profits. These include depreciation and debts. In this regard, it is paramount for firms to emulate provisions for doubtful debts and provisions for depreciations that are important to fund revenue and capital expenditure that are expected to occur in future. In the books of accounts, provisions are credited to the respective account and debited to profit and loss account. This section below discusses the need for more detailed guidance on accounting for provisions Restructuring provisions It is worth to note that unnecessary provisions can be used by companies to artificially influence profits with an aim of attracting more investors. More guidance is needed to assist organizations on how provisions should be measured. Most importantly, provisions should be appropriately estimated in order to settle a current obligation that is faced by an entity. This implies that a company should consider three key issues. First, a company must take into account the number of uncertainties and risks that are associated with an event. It is prudent for firms to note that occurrence of uncertainties is not a justification for excessive provisions (Salterio, 1994). Secondly, a company must consider future events that depict a high level of evidence that they will take place. Thirdly, firms should have adequate information on the time value of money. This is based on the fact that the time value of money is important when discounting the provisions. Debt and provision management In their day to day operations, companies sell their products on credit to maintain their customers. However, some of the debts remain unsettled at the end of the accounting period. More guidance is therefore needed to instigate proper management of bad debt expense. Bad debts expense is a record of the expenses that are incurred through the risk of uncollected debts at the end of the accounting period. Guidance on the accounting provisions is significant in streamlining the duties of the credit managers. It is worth to note that one of the major roles of credit managers is to make provisions for bad debts. Thorough guidance on accounting provisions helps the credit managers to undertake extensive analysis to make appropriate decisions. For example, as some managers adopt a fixed percentage of the accounts receivables to come up with a provision, others consider the time taken to collect the debt. Making of provisions regardless of the method adopted by the credit managers is significant in avoiding overstating of the company profits and reporting of the actual net income of an organization. Proper management of provisions especially for companies who use credit cards and banks is an important aspect that ensures the reliability of their financial statements. One of the key accounts that are maintained by such organizations is the loan loss reserve. This entails the funds that are set aside by banks to cover for unpaid loans at the end of an accounting period. Even though the loan loss reserves reduce the company profits, they ensure adequate funds to cover for the losses. Taxation of provisions One of the major expenses that companies incur is tax. This means that more guides are needed to make companies have effective ways of computing tax that is associated with the provisions made. For example, companies should maintain a provision for depreciation that has an implication on the tax returns as well as on the financial statements for a particular financial year. Part (b) (ii) As mentioned earlier, provision entails liabilities that are of uncertain amount or timing. This means that any business activity that does not meet these criteria does not qualify to be a provision. These include trade payables and expenses that accrue during business transactions. Even though some regions treat provision to stand for doubtful debts and depreciations, IAS 37 does not emphasize such a principle. According to IAS 37, provisions are recognized in the financial statements if it meets three key factors. First, a current obligation must be generated from a past event. Secondly, the amount set aside for provision purpose must be reliably estimated. Thirdly, the probability of making the payment must reasonable. An obligation that is generated from a past event can either be legal or constructive. IAS 37 depicts that a legal obligation is the one that is stipulated by legislations that govern a particular country. In addition, a legal obligation can arise if a contract existed between the parties for example a company and the creditors. On the other hand, a constructive obligation is generated by the operations of a company (Mason and Gibbins, 1991). For example, through the company policies, financial statement and the strategies applied in the past, an organization is in a position to indicate to other parties that it can undertake wide range of responsibilities. Through the policies that organizations publish in their financial reports, other parties can rely on their ability to discharge the stipulated duties. Measurement of Provisions To have adequate provisions, it is vital for companies to have the collect estimate of expenditure that is needed to transfer to third parties or to settle the obligation that are depicted by a balance sheet at the end of financial year. This implies that various events emulate different method of measuring provisions. For example, organization should allocate the most likely amount to provide for environmental clean-up, lawsuit and restructuring of an organization. In the same way, the method of weighted expected value that is arrived at through probability should be used to measure provisions for events that occur in large number for instance refunds given to customers and warranties (Beattie et al, 2001). IAS 37 stipulates that the two methods are used at discount present value. Companies should also seek more guidance on how to treat reimbursement from third parties that is used to settle a provision. In such cases, IAS 37 maintains that companies should not treat such a reimbursement as a reduction of the provision but as a separate asset. Remeasurement of provisions To ensure that financial statements portray adequate provisions needed to meet the liability of the company, IAS 37 advocates for remeasurement of provisions. This means that at each balance sheet date, the company should adjust provisions after undertaking a review of the underlying debts and other liabilities. In the same way, the company should reverse the provisions to revenue if there is no certainty of further outflow (Gendron et al, 1990). The table below indicates various examples of events that are faced by companies and their treatment in the financial statements. Event Treatment closure or reorganization of a company A provision is accrued if a company makes a formal plan that is announced to shareholders and other parties. It is vital not to rely only on the directors decisions. Refunds made to customers If the policy of the company is to give refunds, a provision should be accrued. Customer should be aware of the refunds policy of the company when purchasing the company products. sale of a company operation A company should ensure a formal agreement that binds the parties concerned exist before a provision is accrued. Major company repairs Since there is no obligation, a provision should not be accrued. Source- (Nelson et al, 2003) Works Cited Beattie, V., Brandt, and Fearnley, S. Behind Closed Door. What Company Audit is Really About, 2001. Carpenter, B. Dirsmith, and Gupta, P. Materiality Judgements and Audit Firm Culture: Social-Behavioral and Political Perspectives. Accounting, Organizations and Society,1994. Dirsmith, M.W., and M.E. Haskins. Inherent Risk Assessment and Audit Firm Technology: A Contrast in World Theories. Accounting, Organizations and Society,1991. Emby, C. and M. Gibbins. Good Judgment in Public Accounting: Quality and Justification. Contemporary Accounting Research,1988. Gendron, Y., Bedard, J., and Gosselin. Forthcoming. Getting inside the black box. A Journal of Practice & Theory,1990. Gibbins, M. and A.K. Mason. Professional Judgment in Financial Reporting. CICA Research Study Series. Canadian Institute of Chartered Accountants, 1998. Gibbins, M., .J. Richardson and H. Waterhouse.The Management of Corporate Financial Disclosure: Opportunism, Ritualism, Policies and Processes. Journal of Accounting Research ,1990. Mason, A. K. and M. Gibbins. Judgment and U.S. Accounting Standards. Accounting Horizons,1991. Nelson, M,.A. Elliott and R. Tarpley. How are Earnings Managed: Examples from Auditors. Accounting Horizons,2003. Salterio, S. Researching for Accounting Precedents: Learning, Efficiency and Effectiveness. Contemporary Accounting Research,1994. Read More