International Accounting Standard: IAS 17 Leases - Essay Example

? International Accounting Standard – 17 Accounting for Leases IAS 17 - Leases The objective of IAS 17 is to suggest, for lessees and lessors, an appropriate accounting treatment and disclosures to apply when accounting for leases. The objective of the standard seems to be quite clear on the matter. Before the standard was introduced; different treatments where in practice to deal with the matter of leases. The difference caused the Financial Statements to be un-comparable and increased chances of window dressing the accounts. Many instances were reported by the relevant stakeholders, where the management had concealed liabilities by classifying a lease as an operating lease where it should have been classified as a Finance lease based on the economic reality. To cater these issues IASB drafted and enforced a proper standard “Accounting for leases”. As the objective indicates, the standard has been divided into two main sections, Operating Lease and Finance Lease. This particular classification has been based on the transfer of risk and rewards of the underlying asset to lessee or lessor. Further aspects distinguishing the leases are discussed below in detail. The scope of the standard proposes it's non – applicability on the following areas: “Leases to explore minerals, oils, natural gas and similar non-generative resources; Licensing agreements for items as motion picture films, video recordings, manuscripts, patents and copyrights (because they are under scope of IAS 38). IAS 17 shall not be applied as the basis for measurement for leases discussed under IAS 40 (Investment property) and IAS 41 (biological assets). The standard will not apply to contract of services that do not transfer the right to use assets from one contracting party to the other”. (Financedoctors, n.d.) The standard has been further segregated into two aspects. One is the Lessor accounting and the other is the Lessee accounting. The theory remains the same for both; it is just the nature that changes. For example if a person (Lessee) leases a car from a Bank (Lessor) and the lease is classified as a Finance lease, it will appear as an asset in the books of Lessee along with the relating Finance Lease Obligations (FLO). In the books of the Bank, it will appear as an Investment held as finance lease with its relating receivables. The classification is explained below in further detail with the criteria defined by the standard as to when a lease is described as a Finance Lease. (Deloitte, 2012) Let's consider the implications of a Lease agreement from the perspective of Lessee. An operating lease is fairly simple to understand and account for. Lease payments under an operating lease arrangement are documented as an expense in the Statement of Comprehensive Income. The distribution of expense is usually done on a straight line basis over the lease term, unless a more logical basis provides a better representation. In the case of operating lease, the asset is not recognised by the lessee in his books of accounts. Instead the asset remains the property of the Lessor, and only used by the lessee in exchange for rentals, recognised as expense for the lessee. (Deloitte, 2012; BPP, 2012) Finance lease becomes a little tricky to curtail. As under a finance lease agreement the asset is recognised in the books of the Lessee and subsequently depreciation is charged for the asset in the books of Lessee. Simultaneously, a liability is constructed in the Lessees books in relation to the leased asset. The classification is subject to certain criteria laid down by the standard. An asset is classified as a finance lease subject to the agreements economic reality rather than its legal form. The main factor to be considered is the transfer of risk and rewards. (Deloitte, 2012; BPP, 2012) Circumstances that would lead to a lease being classified as a finance lease are; “transfer of ownership to lessee at the end of lease term, the Bargain Purchase Option at the end of lease term, the lease term in 75% or more of asset’s economic life, Present Value (PV) of Minimum Lease Payment (MLP) is 90% or more of Fair Value (FV) of asset, the leased asset is of such specialized nature that only lessee can use it without major modification, lessor’s losses associated with the cancellation of lease are borne by the lessee and Gain or losses from the fluctuation in FV accrue to the lessee etc”. Under all the above situations, normally a lease will be classified as a finance lease. (Whittington & Delaney, 2010) From the perspective of the Lessor, let us consider the lease implications: In case of operating lease, the asset leased out will not be de-recognised from the books of Lessor, based on the fact that significant risk and reward is not transferred to the Lessee. Lessor will continue to recognise the asset and it subsequent depreciation. Further a rental income will be acknowledged in the Statement of Comprehensive Income of the lessor. The distribution of income is usually done on a straight line basis over the lease term, unless a more logical basis provides a better demonstration. (Deloitte, 2012; BPP, 2012) Finance lease purpose much complex implication for its accounting. Under a finance lease arrangement, Lessor de-recognises the asset from his books and reclassifies it as a receivable in his Statement of Financial Position. Depreciation is seized to be charged and Finance Income is taken into account in the Statement of Comprehensive Income. The standard covers another aspect of lease transaction, known as the sale and lease back agreements. A sale and leaseback transaction engages in the sale of an asset and leasing back of a similar asset. The lease payments and the sale value are usually mutually supporting because they are negotiated as a package. The sale does not represent an actual sale on the basis of its economic reality. Therefore the transaction is accounted for as a lease agreement rather than a sale agreement. In an operating lease scenario the above agreement will act as a sale. The economic reality of an operating lease indicates that the asset has been transferred, and the relating risk and reward transfers with it. Under such circumstances the transaction is treated as a sale and the asset leased back, is treated as a normal operating lease. (Deloitte, 2012; BPP, 2012; NandaKumar, 2010) The initial and subsequent measurement criteria set out by the standard is important to consider, if one needs proper understanding of the subject under debate. Under operating lease since the asset leased out is neither recognised or derecognised, only lease payments become a part of the financial statements. These lease rentals can be paid or received in advance and can be accrued depending upon the agreement drafted. Under a finance lease setup the asset is recognised in the books of the lessee and a receivable is carried in the books of lessor at lower of; cost less cost to sell and the present value of minimum lease payments. Finance Income and Finance cost is booked respectively. Similar to operating lease, a finance lease can be in advance and on accruals basis. Further as discussed above, depreciation is taken into consideration by the lessee as the risk and reward for the asset is transferred to him (Libby et al, 2011). The major impacts produced by the introduction and implementation of IAS – 17 on the preparation and presentation of financial statements are; a finance lease is capitalized, therefore increasing both assets and liabilities in the Statement of Financial position. As a result, working capital of the company decreases and creates additional leverage. Finance lease obligations are distributed between interest expense and principal re-payments, hence, in the Cash Flow Statement, lease payments are presented under operating activities with part under financing activities. Therefore, operating cash flow increases. Operating lease agreements do not recognize lease obligations. Thus impacting leverage and the Investment ratios, making them understated and are overstated respectively. (Deloitte, 2012; NandaKumar, 2010). For the purpose of explaining the matter effortlessly, let's consider a live example of British Petroleum Exploration & Production Ltd (BP). Following is an extract of Finance lease accounted for, by BP in its books of accounts as at 31 December 2011: The group has acquired it property plant and equipment using finance leases. Under these, the renewal term is mentioned but their no clause mentioned with respect to the purchase option or any other price escalation issue. The lessee holds the liberty towards the renewals. The terms and the stipulations do not pose any financial constraint on the group. The minimum lease payments under finance leases that would be incurred in the future are set out below. (Annual Report, 2011) $ Million 2011 2010 Future minimum lease payments payable within: 1 year 454 153 2 to 5 years 200 535 Thereafter 380 438 1,034 1,126 Less: finance charges (342) (316) Net obligations 692 810 Of which – payable within 1 year 339 117 Payable within 2 to 5 years 99 404 Payable thereafter 254 289 BP is an industry leader in the oil and gas domain. Most of its property plant and equipment is on finance lease as directed by the financial statement extract. Under the finance lease agreement BP has booked its assets and relative liability on Minimum lease payments. The extract shows the break-up of the liability into short-term payable within one year and the rest as Non-current Finance lease obligation (Annual Report, 2011). The main criticism on IAS – 17 is on the issue of recognition of the lease agreement and that the lease agreement do not recognise all lease obligation in the Statement of Financial Position. The problem arises with the two vague definitions of leases, one for operational and the other for financial lease. The distinction between the two rests on the basis of risk assessment, which has to be evaluated for every single transaction. Stakeholders have pointed out many times the difficulty and ambiguity faced in interpreting the Lease implications. Professionals suggest that there should be a common technique to handle both the leases. IASB has been working to develop a standard in line with the stake owner's expectations, but have failed so far to relinquish their complaints. The new draft has already been extensively criticised by the users of financial information. The draft suggests a similar treatment of an operating lease as a finance lease. This treatment is fairly simple; the lessee recognises an asset as “Right to use” leased asset over the lease term with a subsequent obligation for the present value of the rentals for that term. This treatment is consistent with the definition of assets and liabilities in accordance with the IASB framework. (Deloitte, 2012) Bibliography ANNUAL REPORT. (2011). British Petroleum Exploration & Production [online]. Available at: http://www.bp.com/assets/bp_internet/globalbp/globalbp_uk_english/set_branch/STAGING/common_assets/bpin2011/downloads/BP_Annual_Report_and_Form_20F_2011.pdf [Accessed 08 April 2012] BPP LEARNING MEDIA. (2012). Acca - P2 Corporate Reporting (Int) Study Text. Gardners Books. DELOITTE. (2012). IAS-17 – Leases, IASPlus. Available at: http://www.iasplus.com/en/standards/standards/standard15 [Accessed 08 April 2012] FINANCEDOCTORs. (n.d.). Leases (IAS 17) Chapter 11, Financial Accounting. Available at: http://www.financedoctors.net/Notes/106.pdf IFRS FOUNDATION. (2009). IAS-17 – Leases, Technical Summary. Available at: http://www.ifrs.org/NR/rdonlyres/A6A27D4A-1EAB-441E-85E7-2878F30389DD/0/IAS17.pdf [Accessed 08 April 2012] LIBBY, R., LIBBY, P. A., & SHORT, D. G. (2011).Financial accounting. New York, McGraw-Hill/Irwin. NANDAKUMAR, A. K. (2010). Understanding IFRS fundamentals: international financial reporting standards. Hoboken, N.J., Wiley. WHITTINGTON, R., & DELANEY, P. R. (2010). Wiley CPA exam review 2010. Financial accounting and reporting. Hoboken, N.J., Wiley. Read More