Accounting for Leases - Assignment Example

Accounting for Leases According to IAS 17, leases are ified into finance and operating leases Epstein andJermakowicz 659). In finance lease, all risks and rewards are substantially transferred to the lessee. The lessee also has ownership of the assets. Under operating lease, it remains as an expense and ownership remain with the lesser. This assignment focuses on the alternative treatments which the lessee might adopt. Two, it looks into the current accounting treatment of leases. Finally, it will look into the impact of the proposed lease standards on the users of financial statements. a) Three alternative accounting treatments which might be adopted when lessees account for lease transactions. The lessee capitalizes an asset or a liability in the balance sheet using amounts equal to the present value of the rental payments. Generally, there is four criteria’s used in capitalization of lease payments (Nikolai, Bazley and Jones 1120). They include: Transfer of ownership of lease property to the lessee The lease has a bargain and purchase option The term of lease is the major part of the assets economic life The present value of the minimum lease payments to the fair value of the leased asset. In practice, three of the four criteria are difficult to apply due to the controversies involved (Nikolai et al 1117). Criteria number one on transfer of ownership is practical and easy to apply. Our major focus on this discussion is limited to only three criteria’s. a) The bargain and purchase option This criterion gives the lessee an option to either buy the property at a price lower than the expected fair value of the property at the option date deemed exercisable (Nikolai, Bazley and Jones 1117). The difference between the fair value and the option price at the date of inception must be large enough to make the option attractive. For example, Y limited was to lease a Honda for $599 per month for forty months with an option to purchase it for $100 on the 40th month. The expected fair value of the Honda at the end of 40 months is $3,000. As you can see the $100 option of purchasing the Honda is a bargain. Therefore, Y limited should capitalize the lease. The only difficult is determining the fair value of the asset. b) Economic life test criteria When an assets economic life is a major part of the lease term, all risks and rewards are transferred to the lessee from the lesser. Capitalization in this case is therefore necessary. It is difficult to determine the economic life of the asset. In practice, the International accounting and standards board (IASB) requires a 75 percent threshold on the economic life when evaluating the economic life test (Nikolai, Bazley and Jones 1117). For example, assume company X leases Lenovo PCs for a period of two years at monthly payments of $100 per computer. It can also lease these computers for $10 per month on each computer for extra two years. The lease offers a bargain renewal option. It is difficult to determine the estimated economic life especially if the item leased is specialized. c) Recovery of investments test Capitalization is essential if the present value on the minimum lease payments equals or exceeds substantially all the fair value of the asset. At this point, a company can purchase the asset since the minimum payments are close to the fair value. The US GAAP uses 90 percent threshold on fair value in assessing the recovery of investment test (Nikolai, Bazley and Jones 1117). Lessees and lesser also consider all other factors in evaluating the lease classification criteria rather than focusing on a single element. b) Current IAS 17 Leases in the financial statements of lessee In the current International accounting standard, (IAS 17), lessees are required to provide extensive financial statement disclosures on leases than even before (Epstein, Nach and Bragg 866). This is because the accounting treatment for real estate and equipment leasing transactions has changed. In the current lessee standards, all operating leases are to be eliminated effectively from the balance sheet and are to be expensed in the income statement of a company. For example, in the financial statements of mobile streams plc for the year ending 30th June 2012, operating expenses less than a year were expensed. Rent expense has been replaced with the interest and amortization expense. In addition, short-term leases that are one year or fewer are exempted from the new lessee accounting. This means that the short-term leases are not reflected in the balance sheet. Short-term leases rental expenses are shown on a straight line basis over the lease term. Month –month leases are not considered to short-term leases since they can go beyond a period of more than a year. This is because the lessee has the right to renew these leases each month. The present value of rent in case of month-month leases is capitalized based on the expectations of the lessee (Schroeder et al 447). At the inception of the lease period, Finance leases are recognized as assets and liabilities in the balance sheet at amounts equalizing the fair value of the leased property. If the lower the present value of the lease minimum payments is calculated at inception. The lessee recognizes the right-of –use of an asset during the specified lease term as well as liabilities for its obligations to make lease payments. The right-of use over the expected lease period is amortized over the useful life of the underlying asset. Also, interest expense on the liability to making lease payment is recognized using the interest method. The right-to-use includes any related indirect costs such as those associated with negotiation and arrangement of a lease. Examples include the brokerage commissions and legal fees. The discount rate used in determining the present value of rent should be based on the interest rate being charged by the lesser. Otherwise, the discount rate would be the lessee’s incremental rate of borrowing based on the credit rating and the length of the lease period. The lease commencement date is the measurement date. Any renewal options on extending the initial lease term is to be included when there is a significant economic incentive to extend the lease. A finance lease results to depreciation expense for assets that are depreciable as well as the finance expense (Nikolai, Bazley and Jones 1117). This depreciation is calculated in accordance with IAS 38 intangible assets and IAS 16 on property, plant and equipment. In cases where the lessee is not certain whether he will have ownership when the lease period ends, then depreciation on the asset is based on the shorter of the lease term and the useful life (Epstein, Nach and Bragg 866). Leases in the financial statements of lesser Assets under finance lease are recognized in the balance sheet. They appear as receivables and are stated at an amount that equates the net investment value in the lease. On the other hand, finance income is recognized based on a pattern reflecting constant periodic rate of return on the net investment outstanding on the finance lease. Assets held on operating lease are presented in the balance sheet depending on the nature of the asset. The lesser recognizes lease income on a straight line basis over the lease period Sale and lease back transactions With regard to Sale and leaseback transactions resulting to finance leases, there might be excesses which result when the proceeds on sale are greater than the carrying amount (Sachse 19). These excess amounts are deferred at a future date and amortized over the lease term. With regard to operating leases, several aspects are considered. First, if the transaction was carried out using the fair value, then a profit or loss is to be recognized. If the selling price is less than the fair value, the loss is amortized over the useful period as it is compensated for by future rental falling below the market price (Sachse 19). If the fair value is below the sale price, the surplus is deferred and amortized over the useful period of the lease. Finally, if the fair value is less than the carrying amount at the time of the transaction, a loss that equals the difference is immediately recognized. c) The impact of the proposed lease accounting standard on users of financial statements In august 2010, there were proposed changes that were drafted regarding accounting standards on leases (Epstein and Jermakowicz 660). These proposals are anticipated to influence the uses of financial statements. Users of financial statements include the shareholders, government, lenders, stakeholders and the society at large. They use financial reports as tools in decision making (Loska 1). Therefore, their decisions are largely influenced by the economic information they get from the financial statements. It is important to note that there are several changes that are associated with the proposed changes on accounting for leases. With regard to the balance sheet, the changes in assets and liabilities may cause changes in financial ratios which were previously stable (Loska 2). For instance, there is a likelihood that the debt to equity ratios will definitely increase. The increase in debt may trigger technical default on loans but this depends on the existing debt covenants of the entity. Also, creditors might provide waivers to the affected loan covenants given that the change is not a real change on cash obligation but a change in book accounting. However, this technical violation on financial ratio can be used as a negotiating advantage depending on the relationship between the lender and borrower. With regard to the profit and loss statement, the net operating income (NOI) could decline due to early front-loading of interest in the lease life. However, this condition is expected to reverse later in the portfolio’s life cycle. NO1 measures the profitability of an organization. If it is declining investors might pull out their investments. The earnings before interest, depreciation, amortization and tax (EBITA) increase except on short term leases. Long term rent is reflected on below interest and amortization. When EBITA increases, the internal and external metrics for management compensation and contract terms also need to be re-evaluated. For example, compensation for managers based on NOI , which will initially be low when compared to the current accounting standards, there likely will be some discussions at year-end regarding compensation because the changes in accounting treatment has little to do with the performance of the manager. On the other hand, compensation measured on EBITA will report higher income than before. Empirical study done by Deloitte in early 2011 revealed a number of market reactions with regard to the proposed accounting changes. Approximately forty two percent of the market respondents indicated that they would secure short-term leases to reduce liability on the balance sheet. Lesser will in return increase rent on short term leases. Another survey indicated that twenty eight percent of respondents said they would rather buy than lease real estate due to changes in the accounting for leases. This is because there is a difference on the balance sheet when one owns and leases property. Works Cited Nikolai, Loren, Bazley, John and Jones, Jefferson. Intermediate Accounting. Cengage Learning. 2009. Pg 1117-1120 Epstein, Barry and Jermakowicz, Eva. WILEY Interpretation and Application of International Financial Reporting Standards . Wiley Publishers, 2010. Pg 659 and 660 Epstein, Barry, Nach, Raph and Bragg,Steven. Wiley GAAP 2010: Interpretation and Application of Generally Accepted Accounting Principles. Wiley Publishers, 2009. Pg 866 Helmuth, John. How the proposed lease accounting standards may impact businesses. 2012. http://www.sbnonline.com/2012/04/how-the-proposed-lease-accounting-standards-may-impact-businesses/ Loska, Thomas. International Corporate Reporting Lease Accounting, 2011. Pages 1, 2 Menon, Merison. Lease Accounting- Significant changes that can impact your business. 2012 http://www.morisonmenon.com/lease_accounting-%20significant-%20changes.php Sachse, Willem. Accounting for leases. Grin Verlag. 2006. Pages 19 Schroeder, Richard G., Clark, Myrtle W. and Cathey, Jack. Financial Accounting Theory and Analysis: Text and Cases. Wiley Publishers, 2009, Page 447   Read More