Current Developments in Accounting for Leases for Losses - Essay Example

?THE CURRENT DEBATE AND DEVELOPMENTS IN ACCOUNTING FOR LEASES FOR LESSEES EXECUTIVE SUMMARY Leases are an important source of financing for business.Lease facilitates lessee right to use and gain the benefits of fixed asset property to conduct business (Mirza and Holt, 2011). Lease treatment in financial statement is accounted under International Accounting Standards – IAS 17. Recently, under Exposure Draft ED/2010/9 Leases, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) proposed new approach to lease accounting for lessees and lessors. This report provides the discussion regarding the reasons behind aforesaid changes in standards. Maintaining focus from the lessee point of view, this report puts together the new proposal for lessees regarding the ‘right to use’ model. Moreover, it will discuss the impact of proposed changes on the companies worldwide using international standards in the preparation of their financial statements. INTRODUCTION Lease is essentially a form of rental agreement where the owner (lessor) receives rentals from lessee. Corresponding to mentioned rentals, lessee gains right to use the assets (EZ Technical, 2009). Lease is a major source of finance for business and to give the correct picture of business, it must provide the source of this important information in the financial statement (Roberts, Weetman, Gordon, 2008). Currently, lease under operating category does not provide this information (Melville, 2011). Therefore, to ensure the financial statements represent lease transactions in harmony with commercial essence and not in according to the legal form only, International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) proposed new approach to lease accounting (Cotter, 2012). CURRENT STANDARD - IAS 17 IAS 17 distinguishes lease into two categories being operating lease and finance lease based on the transferability of risk and reward. Finance lease, as defined in IAS 17, is an agreement that transfers substantially all the risks and rewards pertaining to ownership of an asset. For defining operating lease it has simpler definition that states any lease agreement that doesn’t fall under the category of finance lease shall be regarded as operating lease (Kelly and Kelly, 2009). Hence, factors determining lease as finance lease are further mentioned below (Kelly and Kelly, 2009): The ownership of the asset is finally transferred to the lessee at the end of agreement term. Risks such as cost of maintenance, obsolescence due to technological advancement etc are all transferred to lessee. Rewards pertaining to right on profit from the usage of asset as well as gaining benefit for its whole useful life are transferred to lessee. The lessee can purchase the asset at a price notably below than its fair value. Or it has right to extend the lease for secondary term at rent considerably below market value. The major portion of useful life or the economic life of assets is accounted in lease term. Usually 75% of asset life is accounted in term. At the time of lease agreement, present value of the minimum lease payments represent the substantial fair value of the leased asset. In case of cancellation of agreement the charges are to be borne by lessee. In the light of these factors, agreement can be defined as finance. In case of the lease agreement does not account for the discussed conditions it shall be then regarded as operating lease. PROPOSED STANDARD- EXPOSURE DRAFT ED/2010/9 LEASES International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) on 17 August 2010 published proposal Exposure Draft ED/2010/9 Leases (Hales, Venkataraman, and Wilks, 2012). This draft suggested new approach to lease accounting for lessees and lessor. The new draft suggested replacement of IAS 17 and change in accounting treatment of lease considerably (Eames, 2011). Specific to lessee, ED/2010/9 Leases proposes “right of use” model where the lessee would recognize right of use asset in their financial statements. This recognition would recognize the right of using the underlying asset in the asset side of its financial statement as other tangible assets. Liability section, in correspondence to the asset side recognition of asset, would also recognize the liability or obligation of the agreed upon payments in form rentals payable over the lease term (KPMG, 2012). ED/2010/9 Leases requires that on being effective, lessees would apply ‘right of use” model to all outstanding lease contracts with the carrying amount equal to liability remaining at the date of application of new standards. Snapshot of the proposed lease model to lessee and an example illustrating the new model is given in figure 1 and figure 2 below: Figure 1: (Ernst & Young, 2010a) Figure 2: (Ernst & Young, 2010a) CRITICISM Critics to IAS 17 constantly focused on the operating lease and held following criticism (Ernst & Young, 2010b): 1. Lease when accounted under operating category does not account for liability leads to incomplete information. 2. Arbitrary distinction between operating and finance lease. 3. When changes are estimated lease transactions are not reassessed. RATIONALE TO SUPPORT THE CHANGE OF ACCOUNTING STANDARD The objective of the ED/2010/9 Leases is to establish principle that both parties in lease contract shall report the complete and duly required information about the business in their financial statement. Lease contract have considerable impact on the amounts, timing and uncertainty of the cash flows arising from leases (IFRS, 2010). All these are not reflected in financial statement as lease being off-balance sheet financing and hence, providing an incomplete picture to financial statement users. The proposed draft focused on eliminating difference between financial and operating lease and requires all leases to be reflected on balance sheet (IFRS, 2010). Lease contract adds to the risk and reward to the firm. Risk associated with expense of assets and reward from the use of asset. Financial statement not carrying details of these risks provides the deviated picture. For instance, considering a firm with the capital structure of 50-50 asset and liability with additional 50 percent of liability incurred through lease. Tough apparently firm has risk equal risk for asset and liability but actually it has 100 percent liability for asset base being half of it. This lack of information provides businesses to stay in line with the enterprise that actually has equal ratio in capital structure (Barton, 2010). Moreover, it also leads to the deceptive information to investor undertaking risk based on the information available in financial statements. Ensuring all lease transaction to be recorded on balance sheet would clear this criticism off. Disclosure of information would also provide more transparent information to the financial statement users (Burkholder, 2008). In addition, the distinction between the two categories that are considered subjective due to no defined boundaries for each category will also be eliminated. Finally, integrating due changes when reassessment is made would also clear ambiguities related to lease asset, liability and its impact on balance sheet (Ernst & Young, 2010b). Hence, updating changes to the lease agreement that were subject to criticism as well increasing transparency in financial reporting all provide ground to introduce an updated lease standard (Huggins & Valletta, 2010). NEW PROPOSED AREAS FOR LESSEES ED/2010/9 Lease has changes proposed for both parties involved in lease contract. Changes ED proposal has suggested for lessee firms are under right of use model. The right of use model accounts for the right to use the leased asset for lease term. It also accounts for the obligation to pay liability of rental payments over the lease term (Leone, 2010). This is the main idea proposed for lessee to provide full information regarding the real impact on asset and debt on balance sheet. Proposed details are as under (KPMG, 2010): 1. INITIAL MEASUREMENT: Lessee shall estimate the liability as the present value of estimated future lease payments in the beginning of lease contract. Initial leas payment will be affected by four factors as discussed under: (KPMG, 2010) a. Discount Rate: rate determined by lessor to lease the asset or lessee’s incremental rate for renting or leasing an asset. b. Lease Term: Term duration of lease is longest possible term of lease that is more likely not to happen. This lease life estimation shall also account for any options of lease cancellation or to extend the term as example below: (Ernst & Young, 2010b) c. Contingent rentals: are estimates based on the probability approach. These rentals will be calculated based on expected change in price index or any other relevant index. Example for same has been expressed in image form below: (Ernst & Young, 2010b) d. Residual Value Guarantees and Term option penalties: would be estimated in a similar way of measuring the contingent rentals and constitute part of lease payments measured initially. e- Deductions: These payment shall exclude any amount that is payable under the purchase option. Also any direct cost incurred by lessee that is recoverable along with any rentals that have already been paid shall be deducted from lease payments. 2. RECOGNITION: Lessee shall only conduct this payment measurement at the initial level. On the commencement of lease agreement, recognition of lease liability and right-of-use asset to be presented on balance sheet. 3. SUBSEQUENT MEASUREMENT ED suggests that lessee shall adopt some effective method to record the asset. For the purpose it suggests that lessee shall amortized the lease asset using effective interest rate method. Unlike the traditional method of lease where the lease rentals are consistent over the term, the lessees are required to reassess the asset on every reporting period. On reassessment the lessee must evaluate if the conditions and the relevant facts identify change of significant level in the liability etc. These changes can arise from technological development causing asset to obsolete immediately or considerable decline in value etc. In such case, the entire components of the recorded liability including contingent rentals, term option penalties as well as lessee’s guarantee of residual value would be assessed again taking into account the effect of the change in circumstances (Lindorff, 2011). Recording of change is with distinction as follows: If reassessment results changes due to change in lease term then carrying amount of liability would be recorded in carrying amount of Right of use asset. If reassessment causes change in contingent rentals, term option penalties as well as lessee’s guarantee of residual value would be included in the right of used asset. Change for the future remaining term of lease would be made part of future terms while for current or prior periods would be recognized as profit or loss. These changes would be recognized under cost or revaluation model. IAS 38 of Intangible Assets shall be used to account for the revaluation gains or losses amortization. IAS 36 of Impairment of asset shall be used to recognize impairment losses and other related recoveries. 4. PRESENTATION Presentation in the financial statements will have two parts; asset side will account asset under right of use asset alike other tangible assets. The liability side presenting entire remaining lease payments shall be presented separately from the remaining financial liabilities (Miller & Bahnson, 2010). EFFECTS OF PROPOSED CHANGES The impact of ED in accounting standards will go far beyond than simple change in accounting treatment. The magnitude of impact will be high on both individual firm with operating lease and overall business market. Retail sector will receive most impact from this proposed change; study declared (Ernst & Young, 2010b). Dissected information states, only two industry groups comprising of Food & Staples Retailing and Specialty Retail will account for 25% of impact. Also there are 34 companies having more than 25% of market capitalization equating to estimated amount of operating lease liability (Ernst & Young, 2010b). Hence, lessees have hard time to prepare and adopt change. Other than overall impact, lessee business will have following impact (Ernst & Young, 2010a; 2010b): 1. IMPACT ON KEY FINANCIAL METRCIS Key ratios such as leverage and capital ratio (debt-to- equity) would deteriorate due to recognition of liability. Positive impact on cash flow would under standard where payments for lease will account as investment under financing activity than as operating activity. Rent expense would be replaced by amortization and interest expense. Though total expense would remain same, however, the new model has effective management with higher expense to be incurred in early days. Eliminated lease rent expense would increase EBITA. Increase in interest expense would reduce the tax but deteriorate interest coverage ratio. This will result in declining capacity of firm in fetching investors as well as more loans. 2. DATA GATHERING Application of proposed standard would require firms to retrieve data regarding lease agreements done earlier but are currently on going. This information includes review of provisions such as lease term (including possible extensions), contingent rentals, guarantees and term option penalties etc. In order to provide comparative analysis, lessee firm would also be required to gather information for two to three past years and relative details regarding the lease agreements in those years (Phillips, Munter, Robinson, & Thomas, 2002). 3. IMPACT ON PROCESSES AND INTERNAL CONTROLS SYSTEMS Current treatment of operating lease in many businesses is being conducted using simple basic software. The new treatment due to constant revaluation requirement and varied income statement treatments would require sophisticated IT systems; increasing cost structure and time commitment of lessee. The new standard would require increased estimates and judgmental capacity that goes to strategic level than just proven accounting by accounting department. In each reporting period it also necessarily requires to continue an ongoing assessment of key of measures and assumptions. Firm would need to assess the disclosure of information made mandatory in new standard. Maintaining balance for the information to remain feasible for the firm would be test for accounting professional for firms as well as strategic management of lessee firms. 4. CHANGE IN LEASE STRUCTURE Declaration of asset and liability on balance sheet would have considerable impact on balance sheet of lessee. To mitigate the incremental burden over balance sheet, leasing firms would apply skills to negotiate and structure their lease arrangements. The companies would, for instance, consider between option of small burden on balance sheet or the capacity to absorb the cost of renewals after every term. There would be less burden on balance sheet in case the short lease term is acquired, saving the debt and capital ratio declining to considerable amount. However, in this case once the lease term is over the lessee would have to incur the cost of renewal every time (Shough, 2011). VERDICT FOR LESSEE FIRMS Operating lease contract is among the widely used accounting standards (Alfredson, 2009). It lends considerable support to the balance sheet once the firm intends to own the liability but not at the cost of burden on its balance sheet (Nobes and Parker, 2010). The debate based on the proposed standard for lease that suggest changes in mainly in operating lease has gained much attention. To mention it is still the proposed version and the final verdict is yet to come. However, it is important to mention that proposed change related to recognizing all lease contracts on the balance sheet is expected to be part of final standard. Therefore, firms shall start prepare and equip themselves with strategies and policies that are able to support balance sheets. Its importance will be more evident once the real picture of financial health of firm will appear on application of this and other updated standards to come (Whitehouse, 2010). References Alfredson, K. (2009). Applying international financial reporting standards. 2nd ed., Milton, Old.: Wiley. Barton, T. (2010). Brought to Account. Employee Benefits, pp. 35-36. Burkholder, S. (2008). FASB leases Project to Focus First on Lessee Accounting, Then Lessors. Accounting Policy & Practice Report, vol. 4, no. 15, pp. 650-651. Cotter, D. (2012). Advanced financial reporting: a complete guide to IFRS. 1st ed., Harlow: Financial Times Prentice Hall. Eames, P. (2011). Accounting and Consulting Insights: A New Standard. Smart Business Northern California, pp. 16-17. Ernst & Young. (2010a). what do the proposed lease accounting changes mean for you? Available from http://www.ey.com/Publication/vwLUAssets/IFRS-Practical-matters-2010-08-23-EN/$FILE/IFRS-Practical-matters-2010-08-23-EN.pdf [Accessed 29 October 2012] Ernst & Young. (2010b). Lease accounting: preparing for changing times. EYGM EZ Technical. (2009). Lessee for lease. Finance Matters. Available from http://www.accaglobal.com/content/dam/acca/global/pdf/Lessee_accounting_for_lease_agreement.pdf [Accessed 30 October 2012] Huggins, B., & Valletta, R. (2010). Emerging Accounting Trends---Accounting for Leases. Healthcare Financial Management, pp. 36-39. IFRS. (2010). Exposures Draft: Leases. Available from http://kjs.mof.gov.cn/zhengwuxinxi/gongzuotongzhi/201011/P020101125448883470059.pdf [Accessed 30 October 2012] Jeffrey W. Hales, Shankar Venkataraman, and T. Jeffrey Wilks (2012). Accounting for Lease Renewal Options: The Informational Effects of Unit of Account Choices. The Accounting Review, vol. 87, no. 1, pp. 173-197. Kelly, M., and Kelly, M. (2009). Accounting for leases – IAS 17 Leases. Available from http://www.cpaireland.ie/UserFiles/File/students/Artilces%202009/P1_Accounting_for_leases.pdf [Accessed 30 October 2012] KPMG. (2010). Briefing sheet – exposure draft ED/2010/9 Leases. 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