Accounting for Leases - Assignment Example

IAS 17-ACCOUNTING FOR LEASES INTRODUCTION: A Lease may be defined as a contractual arrangement in which a party owning an asset (Lessor) provides theasset for use to another or transfers the right to use the asset to the user (Lessee) for an agreed period of time. Leasing essentially involves separation of ownership from the economic use of an asset. MAIN FEATURES OF IAS-17 1The objective of IAS17-Accounting for leases is to prescribe appropriate accounting policies and disclosures for Lessees and Lessors with respect to Finance and operating leases. According to IAS 17, a lease is classified as Finance lease if it transfers substantially all the risks and rewards associated with the ownership of the asset to the Lessee. This classification needs to be made at the inception of the lease itself. Risk, with respect to leasing refers to the possibility of loss arising on account of under-utilization or technological obsolescence of the asset. Reward means the incremental net cash flows that are generated from the usage of the asset over its economic life and the realization of the anticipated residual value on expiry of the economic life. A lease which cannot be classified as a finance lease is known as an operating lease. In the following situations a lease is classified as Finance lease: The ownership of the assets is transferred to the lessee at the end of the lease term The date of exercising that option is given to the lessee and Lessee is most likely to exercise that option. The term of the lease spreads major part of the economic life of the asset. The Present value of the Minimum lease payments equals to substantial part of the fair value of the leased asset. In cases where due to specialized nature of the assets only lessee can use the assets without major modifications being made. In case of Lease of Land and Buildings, The land element is classified as Operating lease unless it is specifically stated that the title of the land passes to the lessee at the end of the lease term. Accounting by Lessees: The lower of present value of Minimum lease payments and fair value of the asset is recognized as an asset and liability. The minimum lease payments are discounted at interest rate implicit in the lease. The Lease payments made to the lessor should be apportioned between the finance charge and reduction of outstanding liability. In case of Operating leases, the lease payments should be recorded as an expense in the Profit and Loss account over the period of lease term on a straight line basis. Accounting by Lessors: The amount of Net investment in the lease by the lessor in case of a finance lease should be recorded as a Receivable in the financial statements. Finance income from a finance lease should be recognized as income so as to reflect a constant periodic rate of return on the lessor’s net investment outstanding. In case of an Operating lease income is recognized over the period of lease on a straight line basis. Sale and Lease back Transactions: 2A sale and leaseback involves the sale of an asset and taking the same asset on Lease. The sale price and Lease payments are interdependent as they are negotiated together as a package. The transactions of a Sale and Leaseback system are accounted for based on the type of lease involved. ISSUES IN ACCOUNTING TREATMENT OF LEASES: a) Classification of Leases: Accounting treatment of Leases in the books of Lessee depends on the nature of Lease. If the lease is classified as an ‘Operating Lease’ liability is not required to be recognized in the lessee’s financial statements. If the lease is classified as ‘Finance Lease’ then the liability needs to be recognized in the Balance Sheet. 3The level of debt reflected in the balance sheet is a concern for some companies as this would reflect a high gearing ratio. Companies trying for borrowing funds would like to keep the existing Gearing ratio at a lower level. In this situation the company would try to Classify the leases as Operating lease so that liability need not be recognized and the company’s financial statements would reflect positive gearing ratio. The Classification of the lease should happen at the inception of the lease. What happens if the classification of lease changes at the commencement of lease? In these types of situations the classification as on the date of inception should be retained. b) Implicit Rate of Interest: 4Implicit rate of Interest is defined as that rate of interest at which the present value of Minimum Lease payments and unguaranteed residual value equals to fair value of the asset. Minimum Lease Payments and unguaranteed Residual values differ in degree of risk, but the same implicit rate is prescribed for both. It is also difficult to determine the implicit rate of interest in practical business situations. c) Renewal or Extension of Lease: 5When a lease term is extended should the classification of the lease be re assessed? Since the option to renew or extend is existing at the inception of lease itself, the renewal does not change the terms of lease at the inception and hence re assessment is not required. However, the renewal should be classified based on the terms and conditions for that period and need not be the same as the original lease. PROBLEMS ARISING FROM THE STANDARD: 6The first and foremost problem arising from this standard and all other American standards is that these standards are rule based and not principal based. In this standard the rule says that if the present value of future lease payments is more than 90% of the cost of the asset when you get it then show the assets on the Balance sheet. Thus, if the present value of future lease payments is less than 90% then the assets are off-balance sheet. So, all the lease agreements try to keep this percentage below 90%, thereby making the substance of the Lease agreement not relevant and the form being given more importance. Companies try to mis use the Standard by classifying the loans taken for procurement of assets as an operating lease in order to show the liability as an off-balance sheet item. 7The decision regarding classification of a lease as Finance lease or operating lease depends on the substance of each lease agreement. The problem arising from the standard is the introduction of subjectivity in determining the type of Lease. The standard says that a lease is classified as Finance lease if “The Present value of the Minimum lease payments equals to substantial part of the fair value of the leased asset”. On the contrary FAS-13 prescribes the bright lines that are 75% or 90% thresholds for the determination of type of leases. 8What IAS 17 has done is to shift the decision about the threshold from the standard setter to the preparer of financial statements and Auditors. And these decisions will be taken without privy to the investors. If information with regard to leases is not available to the investors then the Accounting standards followed by the company needs to be revisited. 9To Classify a Lease as Operating lease the lease should satisfy the ‘90% test’ explained earlier. Thus, companies try to structure larger payments which may result in Lease structure preferable for accounting purposes but would be burden on budgetary requirements. The classification should be based on the substance of the transaction and not based on the legal form. 10Thus, a greater weight should be given to those features or terms of the lease agreement that have commercial effect in practice and are close to the reality of the transaction. IS IT JUSTIFIED TO CLASSIFY MAJORITY OF LEASES AS FINANCIAL LEASE? In most of the leases the lessee enjoys the risks and rewards associated with the asset, thus classifying such leases as finance lease would require disclosure of Asset and Liability in the financial statements. This Treatment would reduce the off-balance sheet items and provide good reporting. 11International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have started a joint project with respect to leases with an intention to bring the off-balance sheet items into the Balance sheet by recognizing the asset and obligations for all lessee leases. 12 Finance Leases are more popular among Small and medium Enterprises as they can enjoy the control over the asset and can own the asset at the end of the lease term. The lessee need not invest huge amounts for purchasing the assets and only need to pay the Monthly lease payments, which would reduce the initial cash outflow for the business. The core issue is accounting for leases lies in the distinction between a finance Lease and Operating Lease. In majority of the cases the companies try to classify the lease as Operating Lease and the accounting bodies are trying to resolve this issue. But at the same time there is no justification to classify majority of Leases as Finance Lease. The classification should be based on the Terms of the Lease and differs from case to case. BIBILOGRAPHY 1) -,-, IAS 17 LEASES,IASPLUS, Available from:< http://www.iasplus.com/standard/ias17.htm>, [ 14 March,2009] 2) IASC foundation staff, -, Technical Summary-IAS 17 Leases, IASB, Available from http://www.iasb.org/NR/rdonlyres/B8ABE9AA-8F5B-4301-866E-ED2D423504E7/0/IAS17.pdf, [15 March,2009] 3) Tom Clendon, 05th Feb 2000, Accounting for leases,AccaGlobal, Available from:< http://www.accaglobal.com/archive/2888864/30941>, [16 March,2009] 4) Yasir Khan, 30th September,2005, IAS 17-changing Face Mark, Accountancy, Available from:< http://www.accountancy.com.pk/articles.asp?id=160>, [16 March 2009] 5) -,26th January, 2007, Consistent Application of IFRS, Available from:< ec.europa.eu/internal_market/accounting/.../070126_issues_paper_en.pdf> [ 16 March 2009] 6) Andrew Sawers,26th March,2008, Sir David Tweedie, IASB chairman, Financial Director, Available From:,[15 March 2009] 7) , 11th July 2007, Lease Guidance under IFRSGAAP, Department of Health, Available from:< http://www.doh.gov.uk/doh/finman.nsf/4db79df91d978b6c00256728004f9d6b/0802897d46bb0bc88025738d004c4ca7/$FILE/RABIG(2007)22A%20Lease%20Accounting%20Under%20IFRS%20GAAP_P1.pdf>, [ 15 March 2009] 8) J Edward Ketz, March,2008, The Accounting Cycle-Arbitrary and Capricious rules:Lease Accounting FAS 13 V.IAS 17, SmartPros, Available from:< http://accounting.smartpros.com/x61146.xml>, [15 March 2009] 9) -,-, Lease Accounting Issues, Leasingideas, Available from:< http://www.leasingideas.com/main/accting.html>, [15 March 2009] 10) -,-,-,Accounting for Leases,Dowload-it,Available from:< http://www.download-it.org/free_files/filePages%20from%2014%20Accounting%20for%20Leases.pdf>, [15 March 2009] 11) -.-, Finance Lease, Wikipedia, Available From:< http://en.wikipedia.org/wiki/Finance_lease> , [15 March 2009] 12) Rick Goldfeller, -,Finance Lease-Not an ordinary lease, EzineArticles, Available from:< http://ezinearticles.com/?Finance-Lease-Not-an-Ordinary-Lease&id=1849516>, [16 March 2009]. 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