Principle-Based Accounting Standards - Coursework Example

Introduction Leasing is a vital activity for a lot of entities as it enables gaining of access to assets, acquiring money and ensures less exposure to risks that are associated with ownership of an asset. Therefore, it is important for all financial statements belonging to a certain entity reflect the leasing activities completely and in an understandable way. The accounting models that exist including the firm valuation model and US Generally Accepted Accounting Principles (GAAP) require that the leasers are classified into either financial leases or operating leases and that accounting of the two classes is done differently by the lessees or lessors. The models have however, received a lot of criticism because it fails to provide the users of financial statements transparency regarding leasing transactions. According to the models, the lessees are not needed to recognize the assets and liabilities arising from the operating leases. This shortcoming has attracted request for a better approach that allows lessees recognize the assets and liabilities.1 The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Boards (FASB) came together to develop a different approach to lease accounting that would ensure that the assets and liabilities that arise from lease transactions be recognized in the financial statements. The two boards developed a revised draft on standard leases. 2After receiving responses from their discussion paper leases, they further went ahead and developed proposals on the Exposure Draft (ED) based on the responses. The earlier discussion paper leases include; the preliminary views, issued in March 2009 and the IASBs initial Exposure Draft Leases and the proposed FASB Accounting Standards update Leases(Topic 840), issued in august 2010. 3 The Main Proposals of the ED Draft The main principle is that the assets and liabilities arising from a lease should both be recognized by an entity. The proposition is that a lessee should easily identify the liabilities as well as the assets within not more than twelve months. 4 A lessee would recognize the right he has of using an asset while also representing his or her right to use the asset that has been leased for the period agreed upon and the liability to make lease payments (the lease liability). The ability to recognize, measure and present expenses and cash flows that arise from a lease by a lessee depend on the fact that a lessee is expected to use more than a significant portion of the economic benefits of the underlying asset i.e. the nature of the underlying asset. The lease accounting model proposes that leases of assets other than property (e.g. aircraft, cars, trucks, equipment) is classified as Type A lease and would: 1. Recognise a right-of-use asset and a lease liability, which was initially measured at the present value of lease of payments 2. Recognize the discount on the lease liability as interest separately from the principle of the right-of-use asset Type B lease include the most leases of property (i.e. land and/or a building or part of the building). The lessee would consider doing the following: Recognise a right-of-use of a given asset and the liability of the lease, which is arbitrarily computed at the present value Recognise the single lease cost, which combines the unwinding discount on the lease liability with the principle of the right-of-use asset on a straight-line basis. In the same way, the lessor would apply accounting depending on whether the lessee is expected to consume more than a significant amount of the economic benefits of the underlying assets, i.e. the nature of the underlying asset. The lease accounting model proposes that leases of assets other than property( e.g. aircraft, cars, trucks, equipment) is classified by the lessor as Type A lease and would: 1. Derecognise the underlying asset and recognize a right to receive lease payments(the lease receivable) and a residual asset(the rights that a lessor hold on the asset in question) 2. Recognise the unwinding of the discount on both the lease receivable as well as the assets as part of the interest earned for the time agreed. 3. Recognise any income that is related to the lease with regards to the period stipulated. Type B lease for the lessor are most leases of property. They would apply a similar approach to the existing operation accounting where the lessor would; 1. Continue recognizing of the assets 2. Recognize any income that will be generated during the term of the lease, typically on a straight-line basis. As Coetzee, & Schmulian explain, during measurements of assets and liabilities arising from a lease, a lessee and a lessor would leave out most variable lease payments and it would be inclusive of any payments that will be charged during the period, given that the lessee has enough economic incentive worth extending the lease or not to exercise the option to terminate the lease. 5Leases that have a maximum possible term of 12 months or less, both the lessee and the lesser would be allowed to make a policy election, by underlying asset class, to apply simple requirements that are equal to existing operating lease accounting. It is the responsibility of an entity to disclose any information that enables the users of financial statements meet their objectives of understanding the amount, uncertainty and timing of cash flows arising from leases. Finally, a lesser and lessor would recognize and measure leases at the beginning of the earliest period that is presented using the modified retrospective approach or a full retrospective approach. 6 The Problem with the Lease Accounting Approach The main problem with this approach, basing the arguments on the lessor accounting and lessee models as follows: The proposals are too complicated and too expensive for preparer’s to implement: This is particular for the measurement of the lessee’s lease liability and the lessor’s lease receivable. Although the proposal has simplified the earlier Exposure Draft in 2010, there are still some complexities. For instance, the draft had proposed that an estimate would be made by the entity of all variable lease payments to be made, both during the non-cancellable period of a lease and during any optional extension periods that the entity considered more likely not to occur. It is not certain whether the lease payments to be made during the optional extension periods would still meet an asset definition for the lessor and liability for a lessee or that it would be difficult to make a dependable estimate of variable lease payments if the amounts to be paid relied on future sales or use of the underlying asset. About the cost issue, there are various costs involved including variable lease payments and the payments to be made during extension periods during the lease and liabilities’ measurement that would outweigh the benefit for users of financial statements. . Questions and answers Question 1: Identifying a Lease This revised 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”. AN entity would determine whether a contract contains a lease by assessing whether: a. Fulfilment of the contract depends on the use of an identified asset b. The contract conveys the right to control the use of the identified asset for a period of time in exchange of consideration A contract conveys the right to control the use of an asset if the customer has the ability to direct the use and receive the benefits from use of the identified asset. Do you agree with the definition of a lease and the proposed requirements in paragraphs 6-19 for how an entity would determine whether a contract contains a lease? Why or why not? If not, how would you define a lease? Please specify fact patterns, if any, to which you think the proposed definition of a lease, is difficult to apply or leads to a conclusion that does not reflect the economics of the transition. Response KPMG does not agree with the definition of a lease and generally all the proposals in paragraphs 6-19 the determination of the possibility that a contract contains a lease by an entity.7 I do not believe just like KPMG the proposals represent any much improvement over IFRIC 4, Determining whether an Arrangement contains a Lease , and the corresponding guidance in ASC Topic 840, Leases. The following are the reason why this is so; I believe ED provides insufficient guidance to differentiate between lease and service contracts. This would be key during implementation of the proposals because of the different accounting results for the leases and contracts because the executor contracts be left out from the balance sheet. The proposals would be helpful if they clearly showed practical and detailed examples of how to distinguish such arrangements The proposed way to determine the right to control an asset would narrow the proposals’ scope and may result in a total change in the meaning of a lease, as some of the contracts that were earlier accounted for as leasing arrangements would no longer be so. This does not tally with the Boards’ mission to improve transparency of the existing lease accounting ensuring that any assets and liabilities that arise from any lease arrangement are recognized. The ED Proposal that regards contract accounting that contains service and lease components is not consistent with the Revenue Recognition ED. The definition in the ED involves subjective judgements; hence more guidance on the application with other on-going IASB projects would be in order.8 Question 2: lessee accounting Do you agree that the recognition, measurement and presentation of expenses and cash flows arising from a lease should differ for different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in underlying asset? Why or why not? If not, what alternative approach would you propose and why? Response: Regarding the right-of-use model, the observations are that, in order to maintain the integrity of this model, only one measurement approach should be in existence. 9According to the Certified General accountants, the single lease expense approach does not work well, especially in Type B contracts. Such contracts should be removed from the proposed new approach. In addition, there is no sound conceptual basis that reinforces the single lease expense approach. The suggestion for type B contracts would be to treat payments under the contract as an expense over the contact term. Thi8s simplifies accounting for lessees Question 3. Lessor accounting Do you agree that a lessor should apply a different accounting approach to different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why? Response: The proposed accounting approaches as argued out by the Canadian General Accountants, is that lessors should apply for Type a and Type B contracts makes a lot of sense. In addition, the proposals are in line with the alternative accounting for Type B contracts lessees is in the earlier response. 10 The lessee and lessor Accounting Models The model proposed in the Exposure Draft considers the rights and obligations created by a lease for the time in exchange for consideration. At the commencement date, the model says that a lessee obtains a right to use the underlying asset for a certain period of time, and the lessor has rightly provided or delivered that. Due to this, the boards have called it the right-of use model. The lessee has a right to use the underlying asset during the lease term and an obligation to pay the lessor for providing the right to use the asset. In return, the lessee has an obligation to return in a particular condition, the underlying asset to the lessor at the end of the lease term. The lessor has the right to receive payments from the lessee for providing the right to use the underlying asset. The lessor retains rights associated with the underlying asset. These are the rules and obligations governing the lessor and lesser according to this model Conclusions Discussion Paper In March 2009, the boards published a joint discussion paper (DP) Leases: Preliminary Views. The paper basically proposed the right-of –use accounting model. The feedback on the DP was very supportive of the accounting model for the lessee. The lessor accounting was not discussed in this paper in detail. The Exposure Draft 2010 In August 2020 however, the boards published another approach which was the Exposure Draft after considering the comment letters following the discussion paper as well as input from their International working group on Lease Accounting others interested in financial reporting of leases. This further developed the right-of-use model of accounting by proposing a dual lessor accounting model where a lessor would recognize a receivable lease and derecognize a portion of the underlying asset for some leases and recognize the underlying asset for others. The boards also developed proposals on the revenue recognition. Exposure Draft 2013/6 The ED 2010 raised concerns about the application of the proposed model to non-public entities. Hence the board consulted widely on the proposals of the draft and had meetings in Hong Kong, the United States and the United Kingdom. Members of the board also participated in workshops, discussion forums, one-to-one discussions and conferences held in different countries. This resulted in the Exposure Draft 2013 model that has been covered in detail in this report. One of the concerns raised following the Exposure Draft 2010, is the effects of the right-of-use asset on profit or loss. The Boards then considered various ways of amortisation. One of the approaches suggested was the ‘whole’ asset approach based on the promise that, during the lease term, the leased item in under the control of the lessee. Accordingly, a lessee would return the item to the lessor at the end of the lease term, in addition to an obligation to make payments. If the lease was for substantially all of the leased item’s expected economic life, the obligation to return the item would be relatively insignificant. In contrast, if the leave was for a short portion of the leased item’s life (and the item was expected to retain virtually all of its value over the lease term), the obligation to return the item would be significant. The Boards considered, under this approach that a lessee would consider the right-of-use asset to be a combination of the underlying asset less an obligation to return that asset to the lessor. The pattern of the amortisation charge and the lease expense recognized by the lessee in each reporting period would vary depending on the extent to which the economic benefits embedded in the underlying asset would be consumed by the lessee. The Boards rejected this approach from the basis of feedback that the approach would be prohibitively costly to apply because of the judgement required and lease volumes that exist. References American Institute of Certified Public Accountants. Code of Professional Conduct and Bylaws: Reprinted from AICPA. Professional Standards. New York, NY: American Institute of Certified Public Accountants Inc., 2013 Bonk, C. J., & Smith, G. S. Alternative instructional strategies for creative and critical thinking in the accounting curriculum. Journal of Accounting Education Vol. 16, 1998, 261–293. Coetzee, S. A., & Schmulian, A. A critical analysis of the pedagogical approach employed in an introductory course to IFRS. Issues in Accounting Education. 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