The International Accounting Standards Board - Example

Introduction The International Accounting Standards Board (IASB) develops high quality accounting and financial reporting standards that aim at addressing the demand for reliable and accurate accounting information by various stakeholders. IASB considers the users of the information, the desired information, existing guidance, the quality of IAS developed and resource constraints while developing the standard. IAS 17 accounting standard outlines the relevant accounting policies and disclosures applied for lessees and lessors. The standard was first published in December 1997 and took effect from 1st January 1999. A later revised version was issued by IASB in December 2003 and took effect in January 2005. In 2009, IAS 17 was amended for annual improvements to IFRS about classification of land leases and the effective date for the 2009 amendments was on 1st January 2010. IAS 17 has attracted intense debate due to its shortcomings such as lack of comparability across entities, minimal disclosures, high compliance costs, complexity in statement analysis and lack of transparency in the information. In this case numerous exposure drafts have been drafted in order to guide proposals for change. The current IAS 17 makes a distinction between the finance and operating lease while the proposals have not distinction between the two. The current standard requires the accounting of operating leases as periodic costs that are equal for each period while the proposals males a distinction by requiring leases cost to be accounted as one amortization part and another interest expense part. Key features of IAS 17 on Leases IAS 17 applies for all lease agreements with exception to lease agreements for minerals, oil, natural gas and other regenerative resources or licensing agreements for videos, copyrights and similar items. IAS 17 does not apply in the measurement of property held by lessees that is accounted as investment property under IAS 40, the investment property provided by the lesser under operating leases (IAS 40), the biological assets that are held by the lesser finance leases such as agricultural biological assets (IAS 41) and biological assets that are provided by the lessors under operating leases (IAS 41). The current standard applies for the transfer of the right to use even though substantial services by the lessor may be involved operation ad maintenance of the asset. The standard excludes the agreements that are service contracts and which do not transfer the right of use from the lessor to the lessee. IAS 17 provides for two types of leases that include the finance lease and operating lease. The finance lease transfers substantially all risks and benefits that accrue from lease agreement and thus a lease is classified as a finance or operating lease depending on the substance of the transaction rather than the legal form. A lease is considered a finance lease if it transfers the ownership of the leased asset by the end of the lease term or when the lessee has the option to purchase the asset a price that is sufficiently lower than the fair value at the end of the lease term. Other basis for classification include when the leased asset is special in nature that only the lessee can use the asset without major modifications or when at the inception of the lease the present value of minimum lease payments amount to almost the fair value of the leased asset. Accordingly, certain situations can lead the lease to be classified as a finance lease such as when the lessee can cancel the lease agreements and bear the lessor’s losses or when the losses and gains accruing from fluctuation of the fair value of the residual accrue to the lessee. Furthermore, the current standard allows the lease to be classified as a finance lease if the lessee can continue the lease for secondary period at a rent that is much lower than the market rent. According to the above classification of finance lease, it is clear that a operating lease is a lease that does not transfer substantially all risk and rewards incidental to ownership to the lessee. The current standard requires classification of every component as either finance or operating lease when the lease entails land and buildings since land has an indefinite economic life. The minimum lease payments (including lump-sum upfront payments) are allocated to the land and buildings in proportion of the relative fair values of the leasehold interest in both land and buildings, but the entire lease will be classified as a finance lease if not reliable allocation can be made. Accounting by lessee under current standard At the inception of the lease, finance lease is accounted as a asset and liability in the stamen of financial position at amounts equal to the fair value of the asset or if lower, the present value of the minimum lease payments. The discount rate is the interest rate implicit in the rate or the incremental borrowing arte and any direct costs are added to the amount and recognized as an asset. The transactions are recorded on the basis of substance over form rather than legal form and thus if lease transactions are not reflected in the lessee’s financial statements they will be understatement of the legal obligations. For subsequent measurements, the minimum lease payments are apportioned between the finance charge and reduction of the outstanding liability and finance charge is allocated for each period while any contingent rents are charged as expenses to the periods incurred during the lease term. Accordingly, the depreciation policy should be in accordance with IAS 16 and IAS 38 or shorter of the lease term and useful life if it uncertain that the lessee will gain ownership of the lease asset at the expiry of lease term. The lessee should also disclose the net carrying amount and notes that include escalation clauses or restrictions such as restrictions on additional debt at the end of the reporting period. For operating lease, the lessee will record the lease payments as an expense in the income statement over the lease term using a straight line basis method unless there is another systematic pattern of accruing benefits. The associated incentives of renewal are treated as rental expense irrespective of the nature or timing of payment. Accounting by the lessor The lessor should record the finance lease in the statement of financial position as a receivable and provide a corresponding record of net investment in the lease. The lessor will recognize the finance income on basis that reflects the return on the net investment in the lease. For an operating lease, the assets are recorded on the balance sheet depending on the nature of the asset. The lessor will recognize the lease income over the lease term while any costs or incentives for the lease agreements are treated as a reduction in rental income over lease term. Lease and leaseback transactions A sale and leaseback transaction involves a sale of an asset and leasing back the same asset. For finance lease, the excess of sales proceeds over the carrying amount are immediately recognizable as income by the lessee or deferred and amortized over the entire lease term. For the operating lease, the profit and loss is recognized immediately if transaction occurs at fair value. If the sale price is below the market value, the profit and loss is recognized except in instances when the loss is compensated by future reductions in rentals that are below market price in which case it is amortized over the period of asset use. If the sale price is above fair value, the excess is deferred and amortized over lease term. In instances when the fair value at the transaction time is below the carrying amount, a loss equivalent to the difference of the two is recognized immediately. Problems arising from IAS 17 The universal objective of accounting standards is to facilitate disclosure of accounting information that will enable the users make informed decisions and thus relevancy and reliability of the information are critical in facilitating informed economic decision-making by the users. The information should be verifiable, material and impartial in order to ensure reliability. Accordingly, it should be consistent and understandable and thus accounting standards ensure consistency through conformity to same accounting treatment to similar events. Leases act as a key source of financing and lessee obtains an asset and incurs a liability and thus there is a need for change in the accounting. Although most leases are reported on the lessee’s balance sheet, there is significant information that is always missing across industries and regions. The investors and financial analysts engage in adjusting the information on off balance sheet leases in the note to the financial statements. In this case, the current standard requires the users to contact analysts to estimate the assets and liabilities that arise from the off balance sheet leases thus increasing the costs involved in disclosing the information to the users. The process of estimating the present value of lease payments is also sophisticated and entails skilled analysts who may use varying techniques in making the estimates. Accordingly, IAS 17 tends to create ‘debt like’ liabilities since many investors and analysts think that the leases payments incorporate an interest component. However, the lessee presents the leased expenses related to off balance sheet leases within operating expenses. The existing framework of IAS 17 makes comparison between entities difficult especially those firms that engage in intensive lease of property, plant and equipment. It is difficult to compare the financial performance of an entity that leases 20 percent of its equipment from an entity that leases 80 percent of its equipments. In this case, the long-term liabilities and total assets are significantly affected by the off balance sheet treatment of leases thus making its almost impossible to compare the performance of entities without adjustments for the off balance sheet items. Another problem created by IAS 17 is the lack of sufficient information since exclusion of the lease liabilities and assets from the balance sheet will present incomplete financial position of the firm. A clear example are retail chain that ultimately liquidated, but had large off balance sheet lease commitments. This standard grants high flexibility on leverage and operating position to the lessees since the liabilities may be even 50 times more than the debt when off balance sheet commitments are taken in to account. Circuit City (US) retail chain had reported a debt of $ 50 million, but the undiscounted operating lease commitments were $ 4, 537 million thus leading to unforeseen liquidation. Changes to IAS 17 proposed in the 2013 Exposure draft The exposure drafts acts as a tool for consulting the public and sets out the specific proposal in form of proposed IAS. IASB and the Financial Accounting Standards Board (FASB) published a revised exposure draft on leases in May 2013 and received extensive feedback on proposals for change. The two boards decided that lessee can recognize assets and liabilities that arise from all leases at the start of the lease. The boards also noted that recognition of leases on the lessee balance sheet was insufficient since investors require additional information to gain the outset. Due to costs and complexity, the lessee should not recognize assets and liabilities that arise from leases of 12 months and less and IASB considered the proposals to provide exemption to leases of small assets such as office furniture and laptops. Another proposed change was the change in the model of recognition and presentation of lease expenses in the lessee’s income statement. In this case, IASB proposed a single model that would entail recognition of interest and amortization for all leases that are recognized in the lessee’s balance sheet. On the other hand, FASB proposed a dual model that retains the current distinction between the finance leases and operating leases in order to avoid changes in the lessee’s income statement and recognize all leases on the balance sheet. In response to the mixed feedback, the board proposed the dual model in order to reflect the economic differences of various leases such as real estate leases that are different from other leases. IASB articulated that there is a link between the income statement and balance sheet and thus a model that separately presents the interest and amortization of all leases recognized in the balance sheet provides a information that is more useful to broad range of users. The lessee is expected to recognize the fixed assets and financial liabilities and corresponding amortization and interest. This approach was proposed since it would avoid any accounting structuring due to use of various accounting methods for different leases. The draft changes considered the conceptual issues of lease accounting since all leases grant the right of use regardless of the nature or remaining life of the leased asset. In this case, all leases must be accounted in a similar manner. The feedback from investors indicated that it was difficult in sometimes to understand why various leases did not amortization or depreciation of the leased asset recognized in the balance or no interest liability on the balance sheet. The approach led to some lessees to measure the lease asset as a balancing figure. According to IASB, the costs of accounting are significant for lessees when assets are recognized in balance sheet and the two approaches do not lead to significant differences in measurement of lease liabilities. IASB model no longer will require lessee to classify the leases thus will result to reduction in complexity in accounting. The lessee will also amortize leased asset like other fixed assets and can use existing fixed asset information to account for all lease assets. Another proposed change was the separation of lease agreement from the service agreements since leases exist when customer controls the right to use the asset while service exists when the supplier has the control of the asset. In this case, service components of the lease agreements must be estimated and excluded from the lease components. Another deliberation was on the measurement of the lease assets and liabilities by the lessee. A lessee measures the lease assets and liabilities using the present value of future lease payments including all costs directly involved in making the lease. However, the board responded to concerns on measurement complexity and excluded the variable payments and optional payments from the measurement. The proposed changes required a lessee to classify cash payments for the principal portion of the liability within the financing activities in the cash flow statement and classify the cash payments for the interest portion of the lease liability in accordance with accounting requirements relating to other interest paid. Example Below is an example of proposed accounting for a 3-year equipment lease (type A) and 3-year property lease (type B) Equipment Property Years 0 1 2 3 1 2 3 Balance sheet Right of use asset 600 400 200 - 414 215 - Lease Liability (600) (414) (215) - (414) (215) - Income statement Operating expense 200 200 200 231 231 231 Financing Expense 45 32 16 Total Lease expense 245 232 216 231 231 231 Substance-over-form concept and its relationship with changes to IAS 17 The concept of substance-over-form outlines that the economic substance of transactions and events must be recorded in the financial statements rather than their legal form in order to provide a true and fair value of the affairs of the entity. The concept requires the management to use their judgment in order to derive the business and economic sense from the transactions and events. The aim is to reflect the underlying realities of the accounting transactions and financial statements should not merely aim at complying with the legal form. Substance-over-form concept is widely used in the accounting for leases due to its reliability and faithful representation of information and thus preparers of financial statements have a responsibility to consider the economic reality of the lease transactions. The IASB and FASB have not fully recognized the concept as a distinct principle from faithful representation and reliability. The current IAS 17 requires the financial statements to take in to account the substance of lease agreements when determining the type of lease for the accounting purposes. For instance, an asset may be leased to a lessee without the transfer of the legal title at the expiry of the lease period. In this case, the substance-over-form concept may consider such lease as a finance lease if the lease term is for the entire life of the asset or if the agreements entitles the lessee to purchase the asset at the expiry of the lease period at very nominal price or when not likely the lessee will be capable of exercising the purchase option. The proposed changes will limit the use of substance-over-form since leases will either be classified as either Type A or Type B lease. The type A lease accounting will remain similar to finance lease accounting, but Type B will be more similar to the current operating lease accounting. According to this approach, virtually all leases will be recorded by lessees in statement of financial position statement and this will encourage the lessee to seek a shorter or flexible lease terms in order to avoid the adverse effect of the lease on the balance sheet. However, the preparers will experience complexity in determining the components of the lease agreements. Type B leases include lease of property (land or building) unless present value of lease payments account for substantial asset value at commencement date. The leases of other assets except property will be classified as Type A leases unless lease term is insignificant part of the total economic life of the asset or the present value of lease payments is insignificant compare with fair value of the asset at inception of the lease. Conclusion Leasing is an important financing activity for many economic entities and accounting for leases must clearly provide sufficient, accurate, comparable and consistent information that will enable investor make informed decisions. The existing IAS 17 requires entities to classify their leases as either finance or operational leases and account for such leases differently. The models do not require operating leases to be recognized as assets and liabilities and thus many users have made numerous requests to change IAS 37 standard framework. IASB has proposed changes that will change the classification, recognition and assessment of the leases thus leading to more comparability and less complexity in lease accounting. Reference List: Rodgers, P. (2007). International accounting standards. Oxford: CIMA Blake, J. (2011). Accounting standards. London: Longman. Collings, Steven. 2011. Interpretation and Application of International Standards on Auditing. New York: John Wiley & Sons. Boobyer, Chris. 2003. Leasing and Asset Finance: The comprehensive guide for practioners. London: Euromoney. Walton, Peter and Aerts, Walter. 2006. Global Financial Accounting and Reporting: Principles and Analysis. New York: Cengage Learning. Opperman, J. 2009. Accounting Standards. Sydney: Juta and Company. Oppermann, H. (2001). Accounting standards. Lansdowne [South Africa]: Juta. Greuning, H. and Greuning, H. (2005). International financial reporting standards. Washington, D.C.: World Bank. Read More