Accounting Lease - Essay Example

LEASES WORK ACCOUNTING LEASE Introduction One of the latest issues in accounting field today is about the proposed changes for accounting lease. Leasing is important for many businesses as part of financial sources and the information behind all the leasing activities are relevant to the investors. The existing lease accounting model has been criticized by many users of financial statements because of its complexity, as assets and liabilities are not recognized, and similar transactions are reported in different manner. Assets and liabilities are understated in the operating lease accounting that is why investors need to adjust the information presented in the statement of financial position that is based more on arbitrary and estimation. The proposed changes have come to address this concern wherein structuring the amount presented in the transaction is reduced to achieve a desired accounting outcome. Also, to decrease complexity, to improve transparency and comparability, and to have more complete financial statements, the IASB and US FASB had published a joint proposal to change the existing standard of lease accounting. The scope of the proposed improvement involves US - SFAS 13 and IFRS - IAS 17 wherein the aim is to develop a new single approach instead of the previous operating and finance lease approaches (ACCA 2009). In the proposed ‘right-of-use’ mode, investors and other users of financial statements need not to make necessary adjustments because all assets and liabilities are now being recognized in the statement of financial position. In this paper, the advantages and disadvantages of the proposed changes from the board exposure draft will be recognized. Also, the impact of the new single approach on the financial statements will be given an appropriate analysis. Advantages and Disadvantages: Proposed Changes to the Accounting for Leases The exposure draft has been published to solicit comments from the public either positive or negative. The board thinks that the advantages of creating a consistent approach will decrease complexity and at the same time increase comparability of financial statements that will outweigh the disadvantages (FASB 2010 p.93). Advantages. Providing a complete presentation of financial reporting information for users of financial statements will increase transparency, and this is one of the major advantages of the proposal (IFRS 2009 p.4). A ‘complete presentation’ in the sense that the understated assets and liabilities arising from all lease contracts will now be identified. All of the company’s leasing activities either in a form of an assets or liabilities will now be recognized in the financial statements particularly in the balance sheet (Schroeder et al. 2011 p.446). Under the existing lease accounting model which is the operating lease, assets and liabilities are not recorded; however the board agree that the classification will now be reflected in the statement of financial position. The lessee’s asset is the right-to-use to the leased item over the lease term and the obligation to pay future rental is its liability. On the other hand, the lessor has the right to receive the payment out of the leased item as well as the deliverable economic benefits. With the removal of classification, the lessors are not anymore required to classify the transactions as operating or finance lease, thus it would be easy for the investors and other users to understand the recording of transactions. Another advantage involves in the measurement of the ‘right-of-use’ asset and the liability to pay rentals. Unlike any other financial liabilities, property, plant and equipment are example of non-financial assets wherein the measurement of the right-of-use is at the opening of the lease term (IFRS 2009 p.36). In the proposal, the cost for a right-of-use asset is required to be measured in consistent with the other non-financial assets treatment to improve comparability between entities. To have less complex and less costly for preparers, the measurement of the lease payment will be at the present value with an appropriate rate. The obligation to pay rentals will be measured initially through an amortised-cost based approach instead of a fair value that reflects current market conditions (IFRS 2009 p.43). Although the measurement varies from each other, the result remains to be consistent in making the financial statements more comparable. With regard to lessor accounting, two approaches are considered: the performance obligation approach and the derecognition approach wherein both are required to record an asset on the statement of financial position. Disadvantages. Many industries believe that when the proposed changes go into effect, an enormous impact will immediately takes place particularly in the preparation of the financial statements. One of the major disadvantages is the measurement of assets and liabilities on a basis of longest possible lease term. This could pave the way that companies will not sign on long-term leases, taking into consideration the effect of the extension of termination of lease. As companies prefer to own rather than lease facilities, the sale-leaseback and net-lease transactions are expected to decline (Mattson 2010). Another disadvantage is the potential changes in the balance sheets of companies who are currently using the operating leases. In the proposal, the board decided to remove the distinction between operating and finance lease, resulting to an increase lease obligation and reported debt-equity ratios on the balance sheet. The debt-equity ratios involve the increase in debt and total assets while the return on assets and working capital will decline. Once adopted, the presentation and measurement of balance sheets will need to be changed making more companies appear to be highly leveraged. Also, as the proposal required capitalisation of lease payments, the payment for services and payment for the right-of-use will not be easily distinguished. Analysis of the Impact of the Proposed Changes on the Financial Statements “A proposed change of lease accounting rules appear to be gaining traction and could have a large impact on both the debt reported on a company’s balance sheet and its earnings before interest, tax, depreciation, and amortization (EBITDA)” (Shea 2009). In the current standard, transactions are classified as finance and operating lease in which the latter can affect the financial statement in terms of profitability and liquidity (Schroeder et al. 2011 p.444). Once the proposed changes have been fully implemented and transactions are recorded as finance lease, the biggest impact of recording will be on the balance sheets of the company. See for instance, the Arabtec Holdings PJSC and its subsidiaries Dubai- United Arab Emirates on their interim condensed consolidated financial information which has accounted its lease payment under the current lease accounting standards (Arabtec Holding 2010). PJSC is treating its lease payments for the land, certain labour camps and vehicles as an operating lease. Hence, assets and liabilities in connection with the lease are not recognized in their consolidated statement of financial position. Instead, the expenses of their payment are recorded in their consolidated statement of income as general expenses. However, if the proposed changes in lease accounting will be adopted, PJSC will be required to recognize their lease payment as liabilities and the right to use the leased item as part of their assets. This is because the classification of operating lease will be replaced with a capital or finance lease. Prior to the usage of operating lease, the recorded debt of PJSC as reflected on their general and administrative expenses will not incur changes; however, upon capitalizing the debt-to-total assets ratio will increase. Other financial ratios that will be affected by the classification of the land, certain labour camps and vehicle are the net income, cash debt coverage ratio and many more. Upon treating the lease payment as capital lease the liabilities and expenses in the balance sheet will increase. PJSC consolidated statement of financial position will recognize an increase lease obligations both on assets and liabilities but the earnings per share and the rate of return on assets will decrease. Conclusion Although there have been some negative feedback about the proposed changes in accounting lease, I see that the changes are good not just to the different users of the financial statements but also to the economy and for all leasing activities. We have to accept the fact that changes are inevitable and because the existing standard does not provide the complete picture of leasing activities, the other way is to grab the option. I am on the positive side knowing that the advantages outweigh the disadvantages. The benefits of increased understandability, transparency and comparability for users of financial statements are within the proposed changes. Also, the investors and other users of financial statements will be benefited from the proposed changes knowing that the preparation as well as the disclosure of the information is well-detailed. The right-of-use will now be recorded as assets and the obligation to make lease payments will now be held as the liability, and all of these transactions will be recorded on the balance sheet. Instead of accounting similar transactions differently, the proposal has contained one model for all leases. Lastly, the board makes certain that the change process will be fair to all the affected parties that is why they are soliciting comments and reactions for consideration before writing the final proposal. References Arabtec Holding (2010) Arabtec holding PJSC and its subsidiaries Dubai - United Arab Emirates: interim condensed consolidated financial information and independent auditor’s review report for the period from January 1, 2010 to June 30, 2010 [Internet], Arabtec Holding PJSC. Available from: [Accessed 22 October 2010]. ACCA (2009) Technical briefing paper: Leases: preliminary views [Internet], ACCA. Available from: [Accessed 21 October 2010]. FASB (2010) Financial accounting series: exposure draft [Internet], Intelligent Workplace Management News. Available from: [Accessed 22 October 2010]. IFRS (2009) Discussion paper - Snapshot: leases-preliminary views [Internet], International Accounting Standards Board. Available from: [Accessed 21 October 2010]. Mattson, B. (2010) Companies brace for powerful impact of lease accounting changes [Internet] National Real Estate Investor. Available from: [Accessed 22 October 2010]. Schroeder, R. G. Clark, M. W. Cathey, & J. M. (2011) Financial accounting theory and analysis: Text and cases. 10 ed. Hoboken, NJ: John Wiley & Sons, Inc. Shea, T. H. (2009) United States: looming lease accounting rules changes: impact on earnings, debt covenants, compensation arrangements, and earnout agreements [Internet], Mondaq. Available from: [Accessed 22 October 2010]. Read More

 

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