Changes in IAS Policies Regarding Accounting for Leases - Essay Example

The Managing Director, Hire-It Plc. Report on Proposed changes in IAS policies regarding accounting for leases Dear Mr. MacHamish, We are all awareby now that there are some changes in pipeline for the International accounting standard IAS 17 Leases. My report would provide at first an introduction to the standard and then conclude on any benefits or drawbacks our company would endure due to the said change. Introduction IAS 17 Leases is an accounting standard formulated by the International Accounting and Standards Board (IASB). The principal objective of this standard is to "prescribe, for lessees and lessors, the appropriate accounting practices and disclosure to apply in relation to leases." The standard has classified leases into two broad types: Operating and Finance Leases Finance Lease A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. Operating Lease A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership. The classification of the lease is dependent on the substance of the transaction rather than the form of the contract. Treatment in the books of lessees Operating Leases In an operating lease, lease payments are recognized as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time-pattern of the entity's benefit. Finance Leases In the case of a finance lease, the lessee recognizes the lease as assets and liabilities in their financial statements at an amount equal to the fair value of the leased property. If the amount is lower, then at the present value of the minimum lease payments, each calculated at the start of the lease. When calculating the present value of the minimum lease payments, the discount rate used is the interest rate implicit in the lease. If this is not practicable to determine, then the lessee's incremental borrowing rate is used. All initial costs of the lessee are capitalized to the asset amount recognized. Minimum lease payments are apportioned between finance charge and the reduction of the outstanding principal liability. The finance charge is set in such a way that it produces a constant rate of interest on the outstanding balance of the liability. Treatment in the book of lessors Operating Leases Lessors present assets subject to operating leases in their balance sheets according to the nature of the asset. Lease income from operating leases is recognized in income on a straight-line basis over the whole lease term, unless another systematic basis is more representative of the time-pattern of the entity's benefit. Initial direct costs incurred by lessors in negotiating and arranging an operating lease is to be added to the carrying amount of the leased asset and recognized as an expense over the lease term on the same basis as the lease income. According to paragraph 56 of the incumbent IAS 17 Leases, Lessors shall, in addition to meeting the requirements of IFRS 7, disclose the following for operating leases: The future minimum lease payments under non-cancellable operating leases in the aggregate and for each of the following periods: 1. Not later than one year; 2. Later than one year and not later than five years; 3. Later than five years. Finance Leases For initial recognition, lessors recognize their assets held under a finance lease in their balance sheets and present them as receivable at an amount equal to the net investment in the lease. The recognition of finance income is to be based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the finance lease. Analysis Now, the above introductory information should put us in a position so as to judge the effect of the proposed changes in the IAS against the benchmark incumbent IAS 17 Leases. Disadvantages The proposed changes in the IAS would render the operating lease to be treated in the same way as a finance lease. For the lessor, an operating lease engaging in an operating lease would mean that the significant risks and rewards incidental to ownership are not passed to him. Increased Accounting Costs and Burden The incumbent IAS 17 Leases, recognizes this fact and treats it in such manner; i.e. the leased assets are not capitalized and shown on the face of his balance sheet, but rather are expensed out over the lease term. The additional accounting labour of valuation, classification of nature of asset and other such accounting burdens associated with capitalization of assets would add to the complexity and inefficiency of this accounting practice. Need For Holding Increased Capital For New Assets The proposed changes would result in the formation of significant new assets for companies having core businesses of leasing. This will lead to companies having the requirement to hold additional capital for these new assets, having a strong impact on capital ratios. Depending on the classification of new assets, companies will have to hold additional capital for lease related assets if they are tangible assets or offset them from their own funds if they are intangible assets. Advantages However, there may be a silver lining. When the lease amount is capitalized and not expensed-out, there is inevitably the situation of finding appreciated net income figures and profitability for the company. Being a public limited company, our foremost responsibility and duty is to safeguard the value and earnings of the ordinary shareholders (the essential owners of the company). Higher net income figures would mean better profitability ratios leading to better share values in the equity markets. Also, higher net income figures would also mean a larger chunk left to be distributed among the shareholders as dividends or to be retained by the company as retained earnings for future use. Ordinary Shareholders' concerns It is obvious from the above lines that Ordinary shareholders (the real owners of a company) would welcome this accounting change as this would ensure a higher profit figure available to be distributed amongst them as dividends. Increased Uniformity in Accounting Up till now, the IASs prescribed different treatments for operating and finance leases in the books of lessors and lessees. With the introduction of this update, the IASB aims to standardize the practice with establishing a unified and common practice of recording and recognizing both, finance and operating leases in the balance sheet and not expending them out in the income statement over the period of the lease. This would hopefully, eliminate confusion and provide an opportunity for other regulatory bodies to adopt this change and reduce extra accounting and training costs in this regard within their respective administrative and legal jurisdictions. Opinion In my conclusion, it is clear that the proposed changes in IAS 17 Leases would have a strong impact on global accounting methods and practice relating to accounting for leases. Changes in Financial Statements and Benchmarks The affect on the balance sheets and income statements would be significant, with companies engaged in active leasing having overstated profits and earnings, but would have their balance sheets heavier on the credit side. Industry's Financial Data Interpretation Changes This would need industry members, prospective investors and government regulatory agencies to get accustomed to changed financial statement benchmarks. Changes in the Global World Keeping the current global financial crisis in mind, there is a strong need for some alterations to be made in the proposed draft. In times like these when capital is in short supply globally, the proposed changes set for 2011 would likely have more negative effects than good effects, if any. Research Sources: 1. International Financial Reporting Standards 2. IAS 17 Leases 3. IAS Technical Summary http://www.iasb.org 4. European Association of Public Banks' correspondence to IASB. http://www.iasb.org/NR/rdonlyres/EA74B3AC-B48F-428C-9065-1F62A35474E2/10897/20090706160701_021_EAPBcomments_DiscussionPaperonIAS17.pdf Read More