International Accounting Standards and Accounting Quality - Term Paper Example

International Accounting Standard (IAS) 17 Key Features of the Current Accounting Standard The International Accounting Standard 17 (IAS 17) Leases contains the provisions for accounting disclosures and policies relevant to leases (Biondi et al., 2011; Tribunella, 2009). The accounting disclosures and policies are stipulated with regard to both lessees and lessors. The purpose of IAS 17 was to set the accounting policies and disclosures that are relevant to be used with regard to operating and finance leases (IFRS Foundation 2011). IAS 17 document entails the objective, scope, classification of leases, sale and leaseback transactions, and transitional provisions. In addition, IAS also prescribes for leases within the financial statements of both the lessees and lessors (Barth et al., 2008). The prescriptions capture both financial leases and operating leases. The main characteristics of IAS 17 include the classification of leases, both the finance leases and operating leases, within financial statements of the lessor and the lessee. Scope The scope section outlines the lease agreements for which IAS 17 is applicable. Additionally, the section also lists various agreements in which IAS 17 does not apply. According to paragraph three of the Standard, agreements transferring an asset’s right-of-use require application of IAS 17 (Selling, 2013). The need for the lessor to provide considerable value of services with regards to the operation and maintenance of the leased assets does not nullify the application of IAS 17. Paragraph two of IAS 17 lists four instances that the standard may not be applied (IFRS Foundation 2011). The agreements are contracts for services lacking a transfer of the asset’s right to use (Selling, 2013). Classification of Leases In classifying leases, the International Accounting Standards Board (IASB) took into consideration of both the lessee and the lessor (Reinstein & Weirich, 2005). Similarly, IASB also took into account the extent to which the lessee or the lessor may accrue subsidiary rewards from the possession of a leased asset. The risks taken into account include the possibilities of losses arising out of technological obsolescence or idle capacity. In addition, the risks also include potential losses due to digression in return as a result of varying economic conditions. On the other hand, the rewards are characterised by the prospect of a profitable operation over the economic life of the leased asset (Kirsch, 2012). The rewards also comprise the gains arising from appreciation in value of the leased asset. Additionally, the rewards also include any realisation of some residual value. A lease is classified into two broad categories: a finance lease or an operating lease. A finance lease conveys a significant proportion of rewards and risks subsidiary to ownership. On the other hand, an operating lease does not convey an important proportion of rewards and risks subsidiary to ownership (Hagberg, 2012). Paragraph 10 of IAS 17 provides five examples of situations in which a lease may be classified under the finance lease category. The situations include leases that entail transfer of ownership of an asset, the option to purchase an asset, and the asset's term of the lease is a considerable part of the asset’s economic life. Additionally, the situations comprise leases that have a minimum value of the lease payments and correspond to the leased assets’ fair value, as well as when the leased assets have a specialised nature. Furthermore, IAS 17 also provides a list of three indicators of situations warranting for the classifying a lease under the finance lease category. Leases in the Financial Statements IAS 17 describes the lease issues pertaining to financial statements from paragraph 20 to paragraph 57. The description is divided into two portions. The first portion that is from paragraph 20 to paragraph 35 is confined to issues that pertain to the financial statements of the lessees (IFRS Foundation, 2011). The second portion that is from paragraph 36 to paragraph 57 outlines the issues relevant to financial statements of the lessors. In describing the financial statements of both the lessee and the lessor, there is a clear separation between the finance and operating leases. The prescription on the finance leases is broken down into three sections namely: the initial recognition, the subsequent measurement and the disclosures (IFRS Foundation, 2011). On the other hand, the prescription on operating leases is focused only on disclosures. Paragraphs 20, 25, 27 and 33 highlight the cardinal principals employed by the lessees in their financial statements. Similarly, paragraphs 36, 39, 49 and 50 outline the core principles to be followed by the lessors in their financial statements. Sale and Leaseback Transactions IAS 17 prescribes the requirements for transactions on sale and leaseback situations. According IAS 17 paragraph 59, when a sale and leaseback transaction leads to a finance lease, the excess income over and above the carrying amount is deferred. Furthermore, the excess proceeds are amortised over the term of the lease. However, paragraphs 61 and 63 of IAS 17 stipulate the requirements for transactions the lead to an operating lease. Disclosures Paragraph 31 of the Standard describes the requirements for disclosure by the lessees on the finance leases. Similarly, the requirements for disclosure by the lessors on the finance leases are given in paragraph 47 of the standard. The requirements for disclosure of operating leases are found in paragraphs 35 and 56 for the lessees and lessors respectively. Key highlights of the Disclosures include the carrying amount of an asset and the minimum lease payments amounts. The minimum lease payments need to be reconciled to the present value of the assets. The disclosures also require recognition of contingent rent as an income for the lessee but as an expense for the lessor. Finally, the disclosures stipulate that important aspects of the leasing arrangement are given a general description. Illustrative Example for Lessee Accounting from Published Financial Statements of Unilever Unilever Company is a public limited company that operates in both United Kingdom and Ireland. January 1 marks the onset of the financial year that ends on December 31. Table 1: An extract from the financial reports Unilever for the year 2014 showing the reconciliation of Free Cash Flow to Net profit section (Unilever 2015) In agreement with IAS 17 Lease accounting requirements, Unilever has an entry that recognises the depreciation, amortisation, and impairment as part of the cash flow from operating profits. Unilever Company had spent 1.432 billion pounds on depreciation, amortisation and impairments costs. Table 2: Financial Instruments of Unilever Plc for the year 2013 (Unilever 2015) Unilever Company Plc is vulnerable to the elements of risks due to variations in the fair value of financial liabilities and assets of Unilever Company Plc. The table above provides a summary of the carrying amounts and the fair values. From the statements, it is evident that there are changes in classification of fair value of the financial liabilities and the financial assets were not significant. The period in consideration was from December 31, 2013 through December 31, 2014. Similarly, movements between the hierarchy classifications of the fair values within that particular accounting period were also not significant. The trade receivables’ and trade payables’ fair value was considered to be equivalent to the carrying amount. The equivalence in fair value and carrying amount is attributed to the short-term nature of the items involved in the transactions. The presence of the carrying amount portfolio is an indicator that the company is engaged in finance leases. In addition, Unilever is the lessee in the lease agreements. The example from Unilever is in accordance with the disclosure requirements of IAS 17. Problems Arising from IAS 17 Determination of the asset to which the classification test can be applied to With regard to IAS 17, a finance lease is defined as a lease transferring significantly the entire risks and rewards subsidiary for possession of an asset. The challenge posed by this definition is in determining which particular asset should be considered (Hagberg, 2012). Hagberg (2012) identifies two approaches that may be employed to resolve this dilemma. First, testing whether the there is substantial transfer of the entire risks and rewards due to the right-of-use of an asset in a case of a sublease. The alternative approach is to test whether there is a significant transfer of the entire rewards and risks of an asset in the case of the head lease. Classification inconsistencies Besides the definition of a finance lease by IAS, a number of situational examples have been provided to supplement the underlying principle in the definition of a finance lease. As a result, some inconsistencies arise (Lightner et al., 2013). The modes of determining the lease payments and the lease term differ. The differences are on the account of the approach using IAS 17 recommendations and the right-of-use approach. Considering two examples of situations, a sublease may be inappropriately classified. The two examples of situations are, first the lease term should last for a significant part of the leased asset’s economic life. Second, the current value of the amounts of minimum lease payments should correspond to the leased asset’s fair value. In a classifying a sublease as a finance lease inconsistencies arise in the measurement For instance, when a sublease happens to be classified under the finance lease category, the intermediate lessor will derecognise the leased asset. Simultaneously, the intermediate lessor will recognise a receivable for the amount equivalent to the net investment made out of the lease (Meyer, 2013). The net investment made out of the lease should be equal to the current value attached to the minimum amount of the lease payments together with the current worth of every unguaranteed residual value. It is possible that gains or losses can arise when the terms of the sublease match the terms of the head lease. The possibility may occur even if the entries of the head lease and sublease are made on the same date. Such a scenario results due to the differences in the way the net investment of the lessee and the right-of-use asset are measured. Additionally, analogous measurement inconsistencies may arise when there is provision for extension or termination the lease, residual value guarantees, the discount rate and purchase options. In classifying a sublease as an operating lease, mismatches occur in the income statement In classifying a sublease as an operating lease, there is a probability for the intermediate lessor to recognise amortisation of the right-of-use asset. Bauman and Francis (2011) are of the opinion that the intermediate lessor will also recognise amortisation of the interest expense on the requirement to pay rentals. Additionally, the rental income due to the sublease over the lease term will be recognised by the intermediate lessor. Consequently, in a number of cases, the intermediate lessors do realise a net loss from such the arrangements especially in the early years (Valletta & Huggins, 2010). The reason for such a loss is that interest and depreciation are typically in excess of the income of operating the lease during the early years. However, in the later years the interest charges reduce hence higher profits that offset the depreciation and interest (Bauman & Francis 2011). When a simple lease is classified as a finance lease, there is no probability of such mismatches arising. The interest income out of the sublease and the interest expense out of the head lease are both recognised by the intermediate lessor (Yu, 2014). The changes to IAS 17 proposed in the 2013 Exposure Draft An entity ought to recognise liabilities and assets arising from a lease is the underlying stance of the proposed thoughts. Subsequently, there is an improvement concerning the existing requirements for leases. A number of existing leases do not require lessee’s recognition of lease assets and lease liabilities. The changes on IAS 17 – Leases proposed in the 2013 exposure draft touch on issues such as lease identification, lease classification, transition and effective. In addition, the 2013 exposure draft also has changes proposed on lease accounting clauses and short-term leases. Lease Definition The proposed 2013 Exposure Draft solidifies the definition of the term lease. The proposed definition specifies that a lease would be a contract. The contract will be dependent on the utilisation of an identifiable asset. The criterion for identification of a lease would be founded on the rights to manage the utilisation of specified assets. As a result, some contracts will fall within the range of the proposed standard while some become obsolete to the new standard. Furthermore, the proposed standard also obliges both the lessor and the lessee to identify separate lease elements of a contract. The lessor and the lessee are also required to account for the lease elements independently from any non-lease element. IAS 17 defines a lease as “an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period” (IFRS Foundation, 2011, p. A768). On the other hand, the 2013 exposure draft defines a lease as “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration” (IFRS Foundation, 2013, p. 7). Lease classification In the classification of leases, the 2013 Exposure Draft diverges from the IAS 17. The 2013 exposure draft classifies leases as either of type A or Type B (International Accounting Standards Board 2013). On the other hand, IAS 17 classified leases as either a finance lease or an operating lease. The 2013 exposure draft requires the application of the consumption principle. The presumption for the consumption principle is “leases of property are Type B leases and leases of assets other than property are Type A leases, unless specified classification criteria are met” (IFRS Foundation, 2013, p. 8). There are different criteria for classification of leases of assets apart from properties. The differences in criteria are targeted at replicating the different natures of property and other assets besides the property (International Accounting Standards Board 2013). Consequently, a significant number of property leases would be classified as type B leases. Similarly, a significant number of leases on other assets would be classified as type A leases. Lease accounting According to Riley and Shortridge (2031), the 2013 exposure draft requires for recognition of a right-of-use asset and a lease liability. The lessee is expected to recognise, measure and present the cash flows and expenses arising out of the lease. The proposed standard stipulates that the lessee should expect to use a significant portion of the benefits embedded in the principal asset. Likewise, the lessor accounting is also dependent on the expectation of the lessee consuming a substantial part of the economic profits embedded in the principal asset (Larsson & Peters, 2011). Short- term lease The proposed standard defines a short-term lease as a lease that has a maximum probable term of 12 months from the commencement date. The 12 month period includes any options to extend the contract. The presence of a purchase option in any lease agreement renders nullifies that lease from being considered as a short-term lease. An amendment on IAS 17 is that the proposed standard allows the lessee to recognise the profit or loss, due to lease payments over the lease term, on a straight-line basis. Similarly, the proposed standard also permits the lessor to recognise the profit or loss, due to lease payments over the lease term, on a systematic basis or a straight-line basis. If another systematic basis is to be used, then it is imperative that the basis bears a greater representation of the pattern upon which income is received from the underlying asset Transition The transitional provisions stipulate that the proposed standards of can be applied retrospectively (Riley & Shortridge, 2013). Alternatively, paragraph 68 states that modification of a retrospective approach can also be followed. Effective date There is no proposed effective date. The dates contained in the proposed standard are a replication of the IAS 17. Concept of substance-over-form The concept of substance-over-form compels that the accounting and presentation of transactions ought to be in agreement with the substance (Kelly & Kelly, 2013) and economic reality of such transactions. The accounting and presentation of the transactions should not be merely based on the legal form of the transaction (Elliott & Elliott, 2011). The initial formal imposition of the substance over legal form was by IAS 17. Elliot and Elliot (2011) points out that the objective of the imposition was to guarantee that the commercial influence of a financial agreement was not made ambiguous by the legal characteristics of the agreement. The imposition of the substance over form concept was particularly intended to avert obscuring of the profitable level of gearing (Elliott & Elliott 2011). Elliot and Elliot (2011, p. 285) asserts that “If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they be accounted for and presented in accordance with their substance and economic reality and not merely their legal form” According to Kelly and Kelly (2013), substance over form concept comprises the utilisation of judgment to acquire the business sense. The need for use of judgment is upon the person preparing the financial statement for transactions and events. The objective is usually to present the financial statement in a form that accurately reveals their actual and real meaning. The concept of Substance-over-form is fundamental to the accurate representation and trustworthiness of information provided by the financial statements. Relationship between substance-over-form and the proposed changes to IAS 17 The proposed changes in the 2013 exposure draft appear to be in contradiction to the principle of substance over form (Crowe Horwath International, 2013). When the exposure draft is compared to IAS 17, the definition of the term “contract” is noted to include a requirement for “enforceable right and obligations.” This requirement is stipulated in Appendix A section of the exposure draft (Crowe Horwath International, 2013). The inclusion of such a concept opens a loophole for various entities. Consequently, the entities can organise the various deals they engage in with the intent of avoiding lease accounting (Garmong, 2012). A typical example of the years often involves related entities entering into verbal that is undocumented agreements. In such scenarios, it is complex to determine the "enforceable rights and obligations" accurately’. In addition, due to non-standardised legal interpretation across the various jurisdictions, the complexity of the determination is further enhanced (Crowe Horwath International, 2013). Bibliography Barth, M.E., Landsman, W.R. & Lang, M.H., 2008. International Accounting Standards and Accounting Quality. Journal of Accounting Research, 46(3), pp.467–498. Bauman, M.P. & Francis, R.N., 2011. Issues in lessor accounting: The forgotten half of lease accounting. Accounting Horizons, 25(2), pp.247–266. Biondi, Y. et al., 2011. A perspective on the joint IASB/FASB exposure draft on accounting for leases. Accounting Horizons, 25(4), pp.861–871. Crowe Horwath International, 2013. 2013-270 Comment Letter No. 397A. , (397), pp.1–5. Elliott, B. & Elliott, J., 2011. Financial Accounting and Reporting, Prentice Hall- Edinburg, pp. 7-780 Garmong, S.K., 2012. The State of Major FASB IASB Convergence Projects, Hagberg, A., 2012. 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Accessed on 5th March 2015 Valletta, R. & Huggins, B., 2010. Emerging accounting trends accounting for leases. Healthcare financial management : journal of the Healthcare Financial Management Association, 64(December 2010), pp.36–39. Yu, G., 2014. Accounting Standards and International Portfolio Holdings. The Accounting Review, 89(5), pp.1895–1930. Read More