Advanced Accounting Theory & Practice - Essay Example

Advanced Accounting Theory & Practice Table of Contents Introduction 3 A Brief Overview of IAS 17 Leases 3 Discussion 4 a)Explanation of the Key Features of the Current Accounting Standard 4 b)Discussion about the Problems Arising From IAS 17 9 c)Explanation of the Concept of Substance-Over-Form and Its Relation to the Proposed Changes to IAS 17 10 Conclusion 12 References 13 Introduction International Accounting Standards (IASs) were primarily issued by the forerunner International Accounting Standards Council (IASC). These are identified to be amended as well as endorsed by the International Accounting Standards Board, which is acknowledged as IASB. IASs that were issued in different fiscal years include Inventories, Depreciation Accounting, Income Taxes, Segment Reporting, Leases and Borrowing Costs. Apart from these, the other IASs can be reckoned as Revenue, Earnings per Share, Investment Property, Discontinuing Operations, Business Combinations and Employee Benefits among others (Deloitte Global Services Limited, 2015). With this concern, the assignment intends to analyse and discuss one of the aforementioned IASs i.e. of IAS 17 Leases. Various aspects including its key features, providing an example for illustrating the effects of this IAS, problems arising from the same and explaining the conception of substance-over-form along with its relation to the proposed changes to IAS 17 will also be taken into concern during the process of execution of the discussion. A Brief Overview of IAS 17 Leases The history of IAS 17, which mainly focused on Lease, can be traced during the year 1980. In this period, the standard was reckoned to be an Exposure Draft E19 Accounting for Leases. Later, in the year 1982, the IAS 17 Accounting for Leases was mainly established. The prime intent of this particular standard is to recommend appropriate and effective accounting based disclosures as well as policies to the lessors along with the lessees that can be applied by them while investing and conducting any lease operation (Deloitte Global Services Limited, 2015). From a conceptual perspective, a lease is fundamentally defined as a contract, which takes place between a landlord, also known as lessor and a tenant who acts as a lessee, affirming that the tenant or the lessee can utilise the property of the landlord or the lessor for a given time in return for a certain amount of payment (Ravindra, 2010). In precise, it can be affirmed that a lease is typically implied as obtaining the right of transferring any sort of immovable possessions such as building or real estate from one party to other in return for making precondition payments (Ashutosh, 2008). Leases can be in spoken as well as written form and can even be in implied or in expressed form (Ravindra, 2010). These can be correlated with the term license, wherein a transferor permits specifically a transferre to use his/her property with respect to the making of precondition payments (Ashutosh, 2008). Discussion a) Explanation of the Key Features of the Current Accounting Standard One of the chief features of the current accounting standard i.e. of IAS 17 Leases can be mainly determined based on its scope. It must be mentioned in this similar concern that the standard gets applied to every lease other than any sort of lease agreements that encompass natural gas, minerals and similar other associated re-generative resources. Apart from this, the other key feature of the above stated standard is that it ensures fair as well as proper treatment of reporting any transaction relating to leases in different financial statements such as balance sheet. While explaining the key facets of IAS 17 Leases, it has been ascertained that the current accounting standard distinguishes the transactions associated with leases into two distinct kinds. These include operating and finance lease. From a theoretical perspective, a finance lease is described as “a lease that transfers substantially all the risks and rewards inherent to ownership of the asset” (KPMG IFRG Limited, 2011; Kelly & Kelly, n.d.). On the other hand, an operating lease is deemed to be certain type of lease other than a finance lease. It is indispensable to classify a lease efficiently so that the financial statements do not get affected with inappropriate posting of the classification on such statements. By taking this into concern the fact that dissimilar accounting approaches are needed for classifying as well as computing varied sorts of leases, the current accounting standard i.e. IAS 17 Leases introduced certain indicators that must be duly considered. In this regard, such indicators include asset ownership, purchasing an asset at a cost, which is below its fair value and lease term among others. This introduction of the indicators is certainly regarded as the other potential feature of the current accounting standard. More importantly, the method of allocating finance as well as operating leases by the stated standard also fall under one of its chief features category. Evidently, the standard introduced two particular methods of allocating the aforementioned leases that include the sum of the digits and the actuarial methods (Rosen, 2012; Kelly & Kelly, n.d.). Illustrative Example In order to illustrate the effects impose by the current accounting standard i.e. IAS 17 Leases on the financial statements, an example has been provided and analysed in detail below. A company entered into a contract on 28 February 2015. Items of certain specialised equipment were leased by the company at a cost of $10, 000 per month, which is payable in advance. The lease terms is for three years from 1 August 2014 and can be cancelled at any point of time by either party to the lease. The equipment would have been cost $2, 25,000, if purchased from the open market and is projected to possess a useful life of 6 years. The above illustrated example denotes the transaction of an operational lease, which gets applied to the conditions concerning the useful life of any property or asset and the present market value of lease payments that make by the involved party. The calculation, based on the above transaction, has been depicted in the following: Equipment (Operating Lease) Number of months provided for the rent: 7 months (August – February) Estimated cost of the equipment per month: $10, 000 Therefore, profit from operations for one year = $10, 000 x 7 months = $70, 000 The above calculated profit from operations would be illustrated in the income statement under the head of operating lease payments amounting to $70, 000. Apart from the above example, a renowned US based company Tesco PLC is taken into concern for discussion for understanding the effects of the current accounting standard i.e. IAS 17 Leases. Based on 2014 annual report of the company, it can be apparently observed that the company recorded the amounts, which are outstanding on behalf of the lessees, under the head of receivables in balance sheet. Nonetheless, the company considered the properties under finance leases as assets in its respective financial statement at the end of the year 2014. Specially mentioning, the operating lease expenses that relate to hiring plant and machinery were recorded in income and expenses statement by the company, which had significant impact on its profitability level (Tesco PLC, 2014). A pictorial illustration has been depicted below for better comprehension of the above stated context. Source: (Tesco PLC, 2014) Apart from the effects of operating leases treated under IAS 17 in the income and expenses statement of Tesco, the impacts of finance lease can also found to be much apparent in balance sheet as well. Identifiably, the company treated finance lease under the category of liabilities, which eventually limited complying with the short-term obligations. In the year 2014, the finance lease of the company amounted to £ (121) million, which was included while calculating total financial liabilities (Tesco PLC, 2014). This can be better understood from the following pictorial representation: Source: (Tesco PLC, 2014) Thus, based on the above illustration, it can be affirmed that the effects of IAS 17 Leases can be better understood in the context of overall performance of the companies operating in dissimilar industries in this present day context. Such effects may limit the companies to meet short-term obligations and also paying off any sort of disbursement within a specific time by increasing total financial liabilities, as such companies regard leases, whether finance or operating, under borrowing and treat the same as liabilities. Apart from having effects in balance sheet, the treatment of such leases under IAS 17 also imposes considerable level of impact in profit and loss statement of the companies. b) Discussion about the Problems Arising From IAS 17 While discussing about the problems that arise from IAS 17, which focused on lease operations, it will be vital to mention that leasing is regarded as an important activity for several business firms or entities. This denotes gaining superior access to assets, obtaining finance from varied potential sources and lessening maximum exposure to risks related to asset ownership. By taking into concern the significance of leasing, it can be inferred that the problems arising from the above stated accounting standard may prohibit the investors to work upon trustworthy representation of the leasing transactions (IFRS Foundation, n.d.). Thus, with this concern, certain problems are witnessed to arise from IAS 17 that may impose adverse impact on the investors towards making effective decisions concerning investments. In relation to the above context, one of the problems, which are deemed to arise from the current accounting standard of IAS 17 Leases, is capitalisation. This is mainly owing to the reason of rising complexities in the respective lease products, which certainly augmented the level of capitalisation at large. It is worth mentioning that the problem associated with capitalisation generally arises due to the incorporation of composite leasing options, irrelevant conditional leasing provisions, unfavourable leasing side agreements and inadequate third-party or user guarantees linked with leasing (Day, 2013). Apart from the capitalisation factor, there also exist certain other crucial problems that arise from IAS 17. In this context, such problems can be related to the factors concerning lease term, break along with upgrade clauses, interest rates and residual guarantees. The lease term problem is generally driven from the stated accounting standard by facing difficulties in assessing the options of extending the lease and also determining the primary period of making payments in relation to a contract made. At certain times, the break clauses often do not become much clear to the lessees, which in turn, lessen the existing value of the least payments make by them. In contrast, the problem of upgrade clauses associated with leasing is also generated due to improper knowledge gain by the lessors in rolling into next lease options (IFRS, 2010). Under IAS 17, it is often observed that the involved parties in a lease tend to calculate interest rates for keeping greater control on their respective borrowing rates. The problem mainly arises at the time when the borrowing rates get increased by possessing inadequate as well as unclear understanding or knowledge about the precise residual value of the lease. Amongst all, the problem of residual guarantees under IAS 17 also arise due to having unclear perception about determining whether the residual value is ought to be included as a final payment required to be paid to the lessor by a lessee. It is projected that the above stated problems that arise from IAS 17 may result into making the stated accounting standard to be replaced with the introduction of other disclosures associated with lease and leasing functions (IFRS, 2010). c) Explanation of the Concept of Substance-Over-Form and Its Relation to the Proposed Changes to IAS 17 The conception of substance-over-form in the context of leasing operations is regarded as a legal form of lease contract, which generates obligations on behalf of a lessee and greater control over any sort of leased asset. This particular conception is reckoned to be ensuring better verifiability, imprecision and comparability of the leased contracts (Nobes, 2004). Therefore, with this concern, it can be inferred that the notion of substance-over-form needs to be assessed as a lawful form for determining the rights of the lessors as well as the lessees in controlling their respective assets and determining direct obligations for the underlying liabilities (IFRS, 2014). The proposed changes to IAS 17 mainly revealed the systems based on which a specific lease contract would be valued. In accordance with the proposed changes made towards this accounting standard, the value of a particular lease contract is ought to be determined based on the lease terms and also the payment periods. One of the changes proposed to IAS 17 is reckoned to be enabling the lessors to identify any sort of prevailing underlying asset and likewise adopt different approaches to analyse performance obligations. While determining and analysing the relationship of the concept of substance-over-form to the proposed changes of IAS 17, it could be ascertained that this perception tends to evade the distinction persisting between operating and finance leases, which gets reflected in the financial statements prepare by the organisations (Larsson & Peters, 2011). By considering the fact that the idea of substance-over-form tends to guide the lessors as well as the lessees in controlling their respective assets and determining obligations for liabilities, it relates to the proposed changes of IAS 17 in the form of including certain significant aspects in the financial statements. In this regard, such aspects include residual value guarantees, value of contingent rentals and consideration of certain options for working upon lease renewal or termination. It is projected that the inclusion of the above stated aspects will certainly establish loyal representation of transactions made in the financial statements with respect to lease transactions or operations (Larsson & Peters, 2011). Conclusion Based on the above analysis and discussion, the current accounting standard i.e. IAS 17 Leases prescribes certain effective accounting disclosures as well as policies relating to lease operations or transactions. Its application to every lease of different nature other than any other lease agreement is one of its key characteristics. Notably, capitalisation problem mainly rise from the above stated accounting standard, which in turn, results in affecting the faithful representation of the financial statements. In this similar context, the concept of substance-over-form is noted to be related with the proposed changes of IAS I7 by including the factors such as residual value guarantees in the respective financial statements prepare by different companies. Thus, in conclusion, it can be affirmed that the proposed changes made towards IAS 17 and the impact of substance-over-form on the same would certainly ensure fair and better treatment of lease operations or transactions in the financial statements. References Ashutosh, 2008. Universal Law Series Land Laws Lease, Licences Rent Control and Slum Clearance in Delhi. Universal Law Publishing. Deloitte Global Services Limited, 2015. International Accounting Standards. Standards. [Online] Available at: http://www.iasplus.com/en/standards/ias [Accessed March 17, 2015]. Deloitte Global Services Limited, 2015. IAS 17 — Leases. Standards. [Online] Available at: http://www.iasplus.com/en/standards/ias/ias17 [Accessed March 17, 2015]. Day, A., 2013. Mastering Financial Modelling in Microsoft Excel 3rd edn ePub eBook. Pearson UK. IFRS Foundation, No Date. Leases. Projects. [Online] Available at: http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Pages/Leases.aspx [Accessed March 17, 2015]. IFRS, 2010. Snapshot: Leases. Exposure Draft, pp. 1-13. IFRS, 2014. Items on the Current Agenda. IFRIC Update. [Online] Available at: http://media.ifrs.org/2014/IFRIC/March/IFRIC-Update-March-2014.pdf [Accessed March 17, 2015]. Kelly, M. & Kelly, M., No Date. Substance over Form. Accounting for Leases - IAS 17 Leases, pp. 1-7. KPMG IFRG Limited, 2011. The Future of Lease Accounting. IFRS – Leases Newsletter, Iss. 6, pp. 1-13. Larsson, E. & Peters, M., 2011. Literature Review. Implications of the New Lease Proposal – A Case Study on a Multinational Manufacturing Company and Its Stakeholders, pp. 2-60. Nobes, C., 2004. Examples. Rules-Based Standards and the Lack of Principles in Accounting, pp. 1-22. Ravindra, D., 2010. Profiting with Lease Options. Trafford Publishing. Rosen, J., 2012. Classification of Lease Contract. The Effects of IFRS Lease Accounting Project on the Swedish Commercial Real Estate Market, No. 136, pp. 1-55. Tesco PLC, 2014. Notes to the Group Financial Statements. Tesco. [Online] Available at: http://files.the-group.net/library/tesco/annualreport2014/pdfs/tescoar14_fs_notes.pdf [Accessed March 17, 2015]. Read More