International Accounting Standards - Essay Example

International Accounting Standards (IAS 17) Introduction In the observance of Generally Accepted Accounting Principles, International Accounting Standard 17 (IAS 17 leases) gives the policies and disclosures of accounting that are applicable to leases and that concern both the lessee and lesser. (Epstein & Jermakowicz 2010). Leases are important to business organisations since they enable them to acquire the use of asset without having to acquire its ownership. They are classified into finance leases and operating leases. In a finance lease agreement, the benefits and risks of ownership of the leased asset are transferred to the lessee, while in an operating lease, the ownership remains to the lesser and the lease period is usually short. Finance lease results to the lessee owning the asset at the end of the agreed lease period. IAS 17 therefore has an objective of prescribing the suitable accounting policies and disclosures that are applicable to finance and operating leases. The scope of application of IAS 17 is to all leases agreements relating to mineral oil, natural gases and other resources that are regenerative. It also does not cover the licensing for videos, films, copyrights and other related items. Additionally, it does not apply to the measurement by lessee of investment property that is held under finance lease, lessee of investment property leased under operating lease, lessee of biological assets held under finance leases, and lesser of biological asset leased out under finance lease (David et al 2007). Key features of the current accounting standard The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) held discussion concerning the accounting regulation for leases. They then came up with a proposed exposure draft in August 2010, following their discovery that lessees of leased property recognise assets and liabilities from most leases. They proposed a feature of classification that firms would use type A or type B classification for leases. Under the classification, type A leases are made up of nearly all equipment leases and interest on outstanding liability on lease and depreciation of right to use the asset were the expenses to be reflected in the profit and loss account. The classification would be for the benefit of determining how firms would recognise revenue and expenses related to lease and what property lessors would record on the balance sheet. The nature of asset is used as a basis for classification. Real estate and property leases would be classified as type B leases and as a result, lessees of property would continue to record the lease expense on a straight-line basis. The proposed draft would then change the existing disclosure requirements (IFRS 2013). The IASB and FASB undertook collective deliberations for more than two years and finally in May 2013 they came up with their latest exposure draft, which had significant differences from the formerly proposed. The key feature for this draft is a right-of-use model. This model would require lessees to recognise their commitment to lease as a liability on the balance sheet and right of use as asset on the debit side of the balance sheet. Another key aspect of the exposure draft is the identification of lease components. This is important in the differentiation of agreements that are leases and those that are service contracts (Stockinger (2014). Those that are leases should be recorded in the balance sheet while those that are service contracts are not recorded. The recording of these separate components then follow. An example that illustrates the determination of lease components in accordance with the exposure draft is in the case where a tenant enters into a lease agreement of a retail space together with the land that surrounds, which is used for parking. The location of the retail space requires the availability of the surrounding space. In this case therefore, the only lease component is the retail space, which is dependent on the land for packing. The tenant will would be unable to use the retail space in the absence of the retail space. The asset on lease therefore is the retail space and the surrounding land just enables the tenant to obtain benefits of using the retail space (Mirza & Holt 2011). There are also key features concerning the lease term, lease payment and the discount rate and reassessment. In this case, the lease term is determined on the day of commencement of the lease, which is based on non-cancellable lease period, time taken to extend the lease in cases where tenant has an economic incentive to extend and the period taken by a termination of lease option where tenant has an economic incentive for not exercising the option. Judgment is made regarding whether the significant economic incentive exists. Concerning the lease payment, the present value of lease payment over the entire lease term is recognised as lease liability for the lessee. The lease payments are an agreement of; the fixed lease payments minus the any received or receivable lease incentives, variable payments that depend on a certain rate, fixed in-substance lease payments that are structured as variable payments, exercise price of purchase option where the tenant has economic incentive to exercise the option and penalties payments for lease termination. Discount rate in accordance with the exposure draft is determined on a basis of lease-by-lease basis. In case of a type A lease, a need may arise for lessor and lessee to reassess the lease payments. This might result to remeasuring of the liability on lease and the right of using the asset. There is also a feature of profit that is to accrue to the lessor. Profit from lease arises where the fair value of the asset is greater than the carrying amount (Mukherjee & Mohammed 2006). Problem arising from IAS 17 The International Accounting Standards Committee had originally issued IAS 17 leases in December 1997. It had replaced IAS 17 accounting for leases, which was issued in September 1982. The International Accounting Standards Board then adopted it in April 2001, and in December 2003, undertook a revision and issued the revised IAS 17 as a starting point for its agenda of technical projects. The problem that arises from IAS 17 is its failure to provide a single approach that would ensure that all the assets and liabilities arising from lease agreements are recorded in the statement of financial position. This is the issue that raised concern for discussion between IASB and FASB. The current treatment of leases has been argued to be too submissive by many of the people who are involved in preparing the financial statements, as well as those involved in their use. This is an attributable result to off-balance sheet financing. The accounting of leases and reflecting them as just expenses in the profit and loss account is insufficient thus there is need for making the required entries in the balance sheet. This further denies the users of financial information a clear account of the leasing accounts of an entity. It limits the decisions and conclusions made by the users of these financial statements. IAS 17 requires the classification of lease by lessees and lessors as either being finance or operating leases in order to determine the accounting models. The models arrived from this classification have however been criticised for failure to meet the need of the users of financial statements. The failure of lessee to record the assets and liabilities in the financial statement therefore has resulted to questioning of the accounting model for leases recommended by IAS 17 (Alexander et al 2007). In addition to assets and liabilities, the measurement and presentation of the expenses and cash flows from the use the leased asset are not reflective enough under the IAS 17. This is because they do not reflect the aspect of the economic benefit from the use the underlying asset. IAS 17 also has a limitation to scope of what it covers. It mainly covers the items of property, plants and equipments and not being so inclusive of intangible assets. Other examples of assets that are limited from the accounting treatment of leases are investment property held for lease, investment property under operating lease and biological assets under finance or operating leases. It limits the accounting of some transactions that would better be accounted for under lease, from being under lease accounting. The probable amendments therefore should be made to deal with the problem that arises from IAS 17. The amendments should see the effectiveness of the accounting models to ensure that the users of financial information are provided with complete and reliable information concerning an entity’s leasing arrangements in the financial statements. The initial stage to the amendments is the shift from classification as finance and operating leases to type A and type B leases. This will therefore be used as the basis for determining the appropriate accounting methods. Changes to IAS 17 proposed in 2013 exposure draft The aim of the proposed draft proposed in 2013 was to deal with the problem that was discovered in IAS 17. The changes that would result from IAS 17 therefore were changes in the accounting for leases. The first change that was effected was the classification of leases from being operating and finance leases to type A and type B leases. Type B leases are leases of property while type A leases are leases of other assets other than property. This is followed by the requirement of recognising assets and liabilities arising from the lease agreement. The entities involved are expected to make the appropriate asset and liability entries in the statement of the financial position. To effect this change, lessees under lease agreements whose term goes beyond twelve months are expected to recognise the assets and liabilities from leases. The liability in this case is the lease payments made and the asset is the right-of-use. In determination of how to account for the lease, the lessee and lessor would classify a lease on the basis if economic benefit derived from the leased asset by the lessor. Changes will also be effected in the measurement of lease assets and liabilities of lessees and lessors on basis that reflects an agreed lease term as being non cancellable together with the periods taken by options and the significance of economic incentive. They will also be made on the basis of being inclusive of a fixed lease payment and a variable payment that is dependent on a certain rate or index. The changes in the lease term as well are effected to allow reassessment of the terms of lease. The change is also reflected on the disclosures with the areas of focus being such as the maturity analysis of lease payments that are undiscounted, reconciliation of amounts and narrative disclosures. The accounting changes for the lessee would include recognising for all leases, the asset and the liability. The lease liability is initially valued at the present value of the lease payments. For type A leases, the subsequent measurement of lease liability would then involve amotisation of liability on a cost basis and that of right-of-use asset on a systematic basis. The systematic basis is expected to give a reflection of lessees’ expectation concerning their consumption of the economic benefits of right-of-use asset. Presentation of the unwinding of the discount should be done on the lease liability as interest. This should be done separately from the amotisation of the right-of-use asset. For type B leases, subsequent measurements will involve the cost amotisation basis to measure lease liability and amotisation of right-of-use asset in each period to enable the lessee to determine on a straight-line basis the total lease cost for the entire lease period (Mukherjee & Mohammed 2006). The changes for lessor accounting would include for type A leases, the lessors ceasing to recognise the underlying asset in their statement of financial position and recognising a residual asset instead and lease receivable. They will be expected to recognise both the unwinding of discount on the residual asset and lease receivable over the entire lease term, as well as any profit arising from the particular lease. When accounting for type B leases, lessors should continue to recognise the leased asset and the lease income on a straight-line basis and over the entire lease period (Alexander & Britton 2004). Substance over form concept Substance over form is a concept governed by Generally Accepted Accounting Principles. It is a concept that focuses on reflecting the true intent of transactions in the financial statements. According to Mukherjee & Mohammed (2006) Substance over form is an accounting concept whereby transactions and other events are accounted for and presented in the books of accounts in accordance with their economic reality rather than in their legal form. The concept advocates for the recording of the economic substance of events and transactions in financial statements rather than the legal form that they possess. It involves the use of judgment by the persons responsible for preparing the financial statements for them to be able to derive the economic substance of events and transactions and to ensure that they reflect the true values in the business. The legal aspects of these events and transactions are important as well but they do not show the true business value or worth. They may therefore be disregarded during the preparation of financial statements so as to allow the inclusion of information that is mere relevant to the users of financial statements. In accounting, substance should take precedence over form in decisions of determining how to record a certain event or transaction. Accountants should aim at determining the substance before representing transactions in their legal forms. The substance of transactions in many cases is different from their legal form and in such cases, the substance should be preferred (Alexander & Britton 2004). The concept of substance over form relates to the changes proposed to IAS 17 in a number of ways. The IAS 17 model of accounting is not in consistence with the substance over form since it focuses with recording transactions using their legal form and not their substance, which reflects the true value. This is for instance illustrated by the lessee’s accounting whereby they just record the expenses in the income statement but there is no reflection of the lease agreement in the statement of financial position simply because the lessee is not the legal owner of the asset. Therefore, the proposed changes concerning the accounting by lessee ensure that the concept is observed. When a lessee enters into a lease contract with the lessor, they acquire the use of asset even though they do not acquire its legal ownership. The lessee should therefore reflect this use of the asset in their books of account. The proposed method of accounting by the lessee therefore recognises the use of substance over the legal form. It requires the lessee to recognise the asset and liability from the lease as well. Though the lessee does not own the asset, they acquire the right to its use from the lease agreement. This right therefore is what should be reflected in the statement of financial position of the lessee (Boobyer 2004). The concept also relates to the changes proposed for accounting by the lessor. The lessor in a lease agreement is the legal owner of the underlying asset. However, once a lease agreement is effected the lessee acquires the possession of the asset while its ownership remains with the lessor. The proposed changes for the lessor’s accounting is that the lessor should exclude the underlying asset from the statement of financial position and instead including the residual asset and the lease receivable. This is in consistence with the substance over form concept since despite that the lessor legally owns the underlying asset, the true value of the asset during the lease period is only attributable to the lease receivable and the realizable value of the asset. Conclusion In conclusion, IAS 17 governs the accounting for leases. It was issued in 2003 by IASB, following the revision of the former IAS 17 leases, which had been adopted in 2001. IASB and FASB raised concerns about its model of accounting for leases. The two accounting boards then initiated a project for development of new approach of accounting for leases. They came up with an exposure draft to effect this and this draft offered changes in accounting for leases from the former IAS 17. It proposed changes concerning the classification of leases as well as the accounting for leases with the inclusion of assets and liabilities from lease agreements into the statement of financial position for lessees and lessors. Reference list Alexander, David, & Archer, Simon. (2008). International Accounting/Financial Reporting Standards Guide 2009. Chicago: CCH. Epstein, B. J., & Jermakowicz, E. K. (2010). Wiley IFRS 2010: Interpretation and application of international financial reporting standards. Hoboken, N.J: Wiley. Alexander, D., Britton, A., & Jorissen, A. (2007). International financial reporting and analysis. London: Thomson Learning. Mirza, A. A., & Holt, G. J. (2011). Wiley IFRS: Practical implementation guide and workbook. Hoboken, N.J: John Wiley & Sons. Epstein, B. J., & Jermakowicz, E. K. (2008). Wiley IFRS 2008: Interpretation and application of international accounting and financial reporting standards 2008. Hoboken, N.J: Wiley. Boobyer, C. (2004). Leasing and asset finance: The comprehensive guide for practitioners. London: Euromoney Books. Mukherjee, A., & Mohammed, H. (2006). Corporate accounting. New Delhi: Tata McGraw- Hill. Alexander, D., & Britton, A. (2004). Financial reporting. London: Thomson. IFRS. (2013). Exposure Draft. ED/2013/6. Retrieved from: http://www.ifrs.org/current-projects/iasb-projects/leases/exposure-draft-may-2013/documents/ed-leases-standard-may-2013.pdf Stockinger, M. (2014). Auswirkungen der reform der leasingbilanzierung nach IFRS: Eine empirische analyse. Read More