Problems and Changes Arising from International Accounting Standards 17 - Essay Example

Leases of Institute Problems Arising From IAS 17 Guidelines for the Recognition and accounting for leases is the subject of the International Accounting Standards 17 (IAS 17). IAS 17 describes how to account for the leases depending on the type of lease. Under this standard, leases fall into two categories: finance leases and operating leases. Under the finance lease, all the risks and rewards that come with ownership are transferable to the lessee. To the lessee, it forms both an asset and liability while to the lessor it is a receivable. On the other hand, operating leases form an expense to the lessee while they remain an asset to the lessor. IAS 17 has undergone many revisions in the past to improve its application. However, even with all the amendments and revisions, it still has some issues that cause problems in its application in accounting for leases. The purpose of IAS 17 is to classify leases and provide the policies to guide how a firm treats leases in its financial statements. The standard has a few exceptions concerning some lease agreements. Some assets are also not part of the standard, therefore, their recognition and treatment do not fall within the standard. For the leases and assets that qualify within the standard, classification divides them into finance and operating leases (IFRS, 2013a, p.771). The determination of the class of a lease as either a finance lease or an operating lease is at the commencement of the lease agreement. IAS 17.4 defines the two classes of leases giving their characteristics. The substance of the transaction, as opposed to the form, determines whether a lease is a finance or operating lease (IFRS, 2013a, p.772). The treatment and accounting for the two classes of leases differs. The lessee recognizes operating leases as an expense. The lease payments appear in the income statement as an expense over the lease term and follow a straight-line basis. The lessor recognizes assets under lease in the balance sheet. The income statement of the lessor recognizes the lease income on a straight-line basis. As for finance leases, their accounting involves recognition both as an asset and liability in the books of the lessee. The value to appear in the books is either the asset’s fair value or the present value of the minimum lease payments, whichever is lower. The lessee also accounts for the depreciation of the asset in accordance with the existing depreciation policies and apportions lease payments between the reduction of the outstanding liability and the finance charge. On the lessor’s books, the accounting for a finance lease recognizes it as a receivable in the balance sheet. The basis for recognition of finance income is a pattern that reflects the rate of return on the net investment outstanding. The differences in the accounting for the two classes of leases cause several problems. Many companies take advantage of IAS 17 to exclude operating leases from their statements. That is mainly through off-balance sheet transactions. As opposed to a finance lease, an operational lease does not appear in the books of the lessee as an asset. That gives the lessee’s balance sheet a misleading picture. It understates the value of assets as well as liabilities in the financial statements of the lessee. It is thus tricky to determine the lessee’s leverage. Some businesses recognize some transactions as operating leases to achieve the off-balance sheet accounting. That complicates matters for stakeholders who use accounting information to determine the lessee’s financial position, as well as the performance of the lessee. The use of different accounting policies to record leases would also limit the information available to stakeholders. That would act as a hindrance to them making informed decisions on the lessee (IASB, 2013, p.2). Changes to IAS 17 in the 2013 Exposure Draft IAS 17 poses some challenges when accounting for leases. Such challenges prompted the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) to seek a way to mitigate such challenges posed by IAS 17. They aim to come up with guidelines that would ensure that there is recognition of assets and liabilities that arise from leases in the balance sheet (Young, n.d., p.1). Their efforts first appeared in 2010 in the publication of the first Exposure Draft. Through the years, the Exposure Draft has gone through deliberation and re-deliberation to arrive at the latest 2013 Exposure Draft. Through the 2013 Exposure Draft, the IASB and FASB propose several changes on IAS 17 Leases. The changes the board proposes in the Exposure Draft aim at making sure there is recognition of leases regardless of whether the leases are finance or operating leases (IFRS, 2013b, p.13). That comes from the realization that regardless of the type of lease, a lease contract creates rights and obligations. The rights and obligations characterize assets and liabilities. That means that all leases need to be accounted for as though they were finance leases. It is inconsequential that the lessor retains all risks and rewards since there is creation of obligations on the lessee’s part. The obligations are the rental payments for the use of the asset in the lease. The International Accounting Standards Board (IASB), through the 2013 Exposure Draft, proposes using a ‘right-of-use’ model to account for leases. Under the model, both the lessor and the lessee recognize the rights and obligations arising from the lease (IFRSb, 2013, p.19). Thus, they both account for them as either assets or liabilities. All the accounting for the assets and liabilities is at the present value of the expected lease payments. Subsequent measurement of the assets and liabilities is pegged on the cost-based method. In a lease contract, lessees acquire the right to use an asset and an obligation to pay lease payments for the leased asset (IFRSb, 2013, p.11). It would follow that the lessee would record as an asset the right to use the asset. The expected rental payments would form a liability. The lessee would initially account for the right-of-use at the present value of the expected lease payments. Then there would be amortization over the lease term (Ernst and Young, 2013, p.7). A lessee also tests the asset for impairment and may revalue the right-of-use (IFRSb, 2013, p.59). Presentation of the right-of-use asset would be within the property, plant and equipment in the Statement of Financial Position. However, it would be separate from the other assets over which the lessee has ownership. For lessors, leases offer a transfer of risks and benefits of an asset. Therefore, accounting for leases should reflect such transfer. In a case where there is a significant transfer of risks or benefits from the lessor to the lessee, the lessor should derecognize the asset (Young, n.d., p.4). On the other hand, a performance obligation approach would be applicable where the risks and benefits significantly remain with the lessor. When de-recognizing, the lessor takes the underlying asset off the balance sheet and accounts for the right to receive payment on the lease. The performance obligation approach creates a lease liability and a right to receive payments on the lease as well as maintaining the asset in the balance sheet. The lease liability is the permission granted to the lessee to use the property. Some leases are more complex comparative to the traditional leases. Such leases may provide options to terminate or renew the contract. They also provide an option for the purchase of the leased asset as well as offering residual value guarantees and contingent rental arrangements (KPMG, 2011, p.6). The proposals indicate that recognition of such provisions or options is not to occur separately from the lease. Rather, there should be a determination on the part of the lessee as to the exercise of such options (Weaver, 2010, p.61). The lessee is to account for the options if they are likely to exercise the option. Confirmation from the International Accounting Standards Board (IASB) indicates that there should be an inclusion of amounts due under residual value guarantees as well as contingent rental arrangements. Given the proposals in the Exposure Draft, financial statements would reflect all assets and liabilities that arise from lease contracts. That would ease the problems associated with IAS 17. It would make use of financial statements by stakeholders easy, as the amount of information available would be sufficient. For that reason, it would be easy to determine the performance and financial position of firms. The proposals would also ensure some uniformity in the accounting for leases. Therefore, investors would be able to make comparisons based on financial statements. Bibliography Ernst and Young, 2013. Implications of the Revised Leases Exposure Draft for the Real Estate Sector. Applying IFRS in Real Estate. IASB, 2013. Exposure Draft ED/2013/6: Leases. London: International Accounting Standards Board. IFRS, 2013a. Basis for Conclusions Exposure Draft Ed/2013/6: Leases. London: IFRS Foundation. IFRS, 2013b. International Accounting Standard 17: Leases. London: IFRS Foundation. KPMG, 2011. The Future of Lease Accounting. IFRS-Leases Newsletter, (6). Weaver, L., 2010. Corporate Reporting: Current Issues. Student Accountant, (17), pp.60-61. Young, P., n.d. 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