Existing Lease Accounting Model

267 views 9 pages ~ 2287 words Print

The existing leasing standard was classified as IAS 17 before the IASB’s review. Existing (older) standards classify leases as either finance leases or operating leases. In an operating lease, the lessee recognizes the expense, but the asset remains with the lessor. On the other hand, the risk of ownership is recognized by the lessee and must be asserted by the lessor. This standard was published in his 2003. IAS 17 focused on types of leases as most companies avoid accounting and therefore prefer operating leases. Both lessees and lessors are subject to different rules (Christian & Lüdenbach, 2013).

Lessee – at the onset, finance leases are documented as assets and liabilities at the lesser of present value or fair value. Lease payments are distributed as finance charge or reduction of outstanding liability. Operating leases are reported as expense in the statements, during the lease term. They are however off-balance sheet expenses while finance lease are recorded on the balance sheet. Disclosures includes the carrying amount of the assets, contingent rent (recognized as an expense), future minimum sublease and non-cancellable lease canons (Christian & Lüdenbach, 2013).

Lessors – at the beginning of the lease term, lessors record the lease in the statement of financial position as receivables; and the values should be the same as net investment in the lease. The lessor is required to recognize finance income on intervallic rate of return on outstanding investment. Operating leases are presented on the balance sheet based on the nature of the asset. Disclosures include amounts of lease payments before or on balance sheet data (Christian & Lüdenbach, 2013).

New Standard: IFRS 16

Lease accounting for companies has been overhauled according to the new set of International financial reporting standards. For the first time, operating leases are required to be recorded in the balance sheet section. This change will impact almost all firms that use IFRS in some way, especially for companies that traditional apply the large lease operating portfolios. The new adjustment is attributed to the need for greater transparency of lease obligation by companies. In fact, the IASB estimates that over 85 percent of companies who used IFRS and US GAAP recorded lease liabilities as off-balance sheet items. The new changes will be effective from the accounting periods beginning after 1st of January 2019.

Effects on Financial Statements

The improved standard will change the way in which the leases would be accounted for. To begin with, the statement of financial position will record every affected lease as a right-of-use-asset and also as a liability, which essentially means the ability to make future lease payments. Consequently, reporting entities with substantial operating leases will have higher debt figures in the statement of financial position. More so, in the income statement, figures recorded for leases will be depreciation charge for leased assets and interest expense on lease liabilities. In addition, rental payment for operating leases will not be presented as operating expenses, as it has been done previously. These changes will subsequently impact on the EBITDA due to expected changes in interest rates. The cash flow statement will also change due presentation of items in an extent that relates to former off-balance sheet leases. Therefore, operating cash outflows will substantially reduce the figures on the balance sheet.

Tax considerations - the new policy will bring about additional tax considerations. It will affect deferred taxes as well as tax differentials, tax processes and controls. The impact of the policy on tax will depend on requirements on specific tax jurisdictions.

The new standard will also require companies to convert current operating leases to lease assets/liabilities. The execution of the standard will result to changes in policies, controls and management operations that support leasing. Also, it will impact on lease procurement and lease administration. It will impact metrics of financial statements due to the need to negotiate contracts that contain leases. As a result, such activities may necessitate participation of a variety of distinct departments within the firm.

Example

To record the initial value of the lease asset and liability worth $ 355, 391, cash amount paid, $ 50, 000 and Right of use of asset is 405, 391. This transaction would be recorded as follows:

Dr. Right of use of Asset $ 405391

Cr Lease Liability $ 355,391

Cr Cash 50,000

To record indirect costs:

Dr. Right of use of Asset $ 20,000

Cr Cash $ 20000

Impact on Financing Agreements

Depending on the draft of the adjusted IFRS, the new agreement will affect the definition of terms and covenants. The lessee will be able to recognize the balance sheet ROU as well as recognize the income statement depreciation of Return on assets. The cash flow statement will entail the amount paid for the principal amount as lease liabilities. This will be recorded in the financing activities section of the cash flows. Lease cash flows should also disclose relevant information regarding the breakdown of lease costs and maturity analysis.

Example

Dr. Right of use of Asset $ 50,000

Cr Lease Liability $ 400,000

The overall effect is that balance sheets will become bigger because leases will no longer be recorded as off balance sheet items. Also, the income statement will offer more detail because it will align the expenses and replace the current straight-line operating expenses. Financial ratio analysis will also be affected because lease expenses will be noticeable by investors especially when analyzing the Earnings before interest and tax. The current EBIT does not include expenses related to leases. There will be a corresponding increase in cash flows especially relating to former off-balance sheet items. Interest expense is usually higher during the earlier and it typically decreases as years elapse. This will definitely affect the cash outflows and inflows.

Lease liabilities will be recorded separately from other liabilities. Therefore, the statements will provide lease liabilities as separate items in the liabilities section. Also, the lessee account will split lease liabilities into two factions namely: current and non-current options. Lessee assets on the balance sheet will recorded under property, plant and equipment or they can be listed as their own item to ensure ease in understanding of the statement of financial position. Income statement will be split into two expenses components that will explicitly recognize the financing element that is usually present in leases. Lease payments and value guarantees should be disclosed in the statements. Increase in income will impact positively on interest rate as well as cover ratios.

Effect of New Lease Requirement on Lessee and Lessor

The new IFRS has introduced a new single lessee accounting model which ensures that leases with terms over 12 months will be recorded in the balances sheet, including first time operating leases (IFRS, 2016). A lessee will recognize a lease for the requirement on the lease payments. It is then adjusted for lease payments and incentives received. The new policy also allows lessee to come up with accounting policies election based on the class of the derivative asset. The lessee will no longer distinguish between an operating lease contract and the finance lease. They should however recognize a right-of-use assets and a supporting lease for all agreements. Subsequent measurement for lessees is done by accreting the lease to reflect reduce liability, in accordance with depreciation and taxation requirements under IAS 16. Depreciation is done using straight line approach and the interest on lease liability generally results in high total periodic expenses. Lessees are also mandated to measure the lease liability upon occurrences of certain events such as change in lease term or change in rent (IFRS, 2016).

Presentation of these accounts are done separately from other assets in the balance sheet. Liabilities are either presented separately in the statement of financial position or disclosed in the summary notes. It is important to note that depreciation and interest should not be merged in the income statement. The most obvious effect of the new IFRS on the lessee is that there will be a substantial increase in the value of recognized assets for companies.

Lessor

The new IFRS has substantially carried forward the lessor’s obligations and other accounting requirements in IAS 17. The lessor will continue reporting leases as operating leases or finance leases but they will be accounted for separately. Therefore, the existing terms will be maintained but there will be greater disclosure requirements. Initial recognition and measurement is done by classifying all the leases using the same principle shown in IAS 17. They should be distinguish between the two common lease types namely: operating and finance lease. Lessors recognize underlying assets in cases of operating lease (Earnest and Young, 2016). On the other hand, finance leases are recognized based on the underlying asset and net investment. These facts are similar to the existing guidelines. Also, any profits, proceeds or losses should be recognize under the underlying asset (IFRS, 2016).Subsequent measurement for income in operating lease is done on a systematic basis. In contrast, lessors measure interest income as an accretion of total investment in a finance lease. Net investments are subjects to de-recognition and impairment as explained by IFRS 9 (Earnest and Young, 2016).

Example

Big-ticket asset operators such as airlines will be affected by the new guidelines. The reason for this is that most of the assets are usually off-balance sheet. Also, the initial recognition of operator’ lease liability and right to use asset will result in increase in operator’s financial liabilities and lease assets upon commencement. Also, the new treatment of sale and leasebacks will impact on the company’s financial options (Davies Tomlinson and Hughes, 2016). While operator’s existing and future corporate liabilities may be affected by the new guidelines, it is worth mentioning that operators of high value and long-life assets lease assets will be affected by other reasons other than accounting treatment. More so, the airline’s supplier and financing arrangements will involve leasing a number of assets and provision of services such a maintenance.

Effects on Singapore Airlines

In Singapore’s case, the risks and rewards will sit with the operating lessor but the cost of operations will remain with the company. The Singapore FRS is slightly different as compared to the IFRS. However, the companies are increasingly adopting the IFRS standards. Singapore Airlines will have to recognize leases on the balance sheet, and this will have a huge effect on the reported profits and performance measures such as debt and gearing ratios. An increase in rental expense for the company will be replaced by amortization, depreciation and interest expenses (Singapore Airlines, 2016). More so, being a multinational entity, the new lease will affect the airline due to currency volatility considering the company has to translate the lease liabilities during reporting dates.

Among other departments that will be affected includes ancillary agreements such as leased contracts on spare parts. Moreover, the company has substantial leased contracts regarding maintenance and lease of intangible assets. From a legal perspective, the parties to the leases will have to review agreements, which requires an understanding of the new standard especially in the calculation of the figures affecting the new covenant. Agreements will have to be reviewed for them feature any provisions entailing contingent rent and similar purchase options (Singapore Airlines, 2016).

Currently, major lease agreements range between 4 years to 30 years. Major improvements of aircraft due to operational mandates are capitalized and depreciated over the remaining period. On the other hand, the lessor retains substantial risks and rewards of ownership. The aircrafts are leased out under the operating lease policy. Rental income is also recognized on straight-line basis. Come 2019, operating leases will be recognized on the balance sheet, which will impact on the company’s gearing ratios, asset returns components as well as the reported profits.

Also, the company’s business model will be significantly affected. For instance, the Singapore Airlines will have to lower their lease periods due to high costs that may be incurred. The standard eliminates classifying leases as either operating or finance leases, rather the standard introduces a single lessee accounting model (Singapore Airlines, 2016). More so, the lessor model is carried forward from IAS 17 with more disclosure requirements.

The standard affects all classes except for lease on biological assets, non-generative resources, licensed on intellectual property and lessee rights under certain licensing contracts. There will be significant increase in costs especially in documentation, educating investors and internal stakeholders. Borrowing costs of the company will increase and they are anticipated changes in business practices (Singapore Airlines, 2016). Other than adding substantial new assets on the lessee’s balance sheet, IFRS 16 will have a huge effect on reported profits and performance measures. IFRS 16 recognizes short term leases as those with 12 months or less (Singapore Airlines, 2016). Therefore, when the firm selects this option, it must classify them as underlying assets and therefore, it will be treated as a subsequent modification or change in lease terms resulting in the use of the new lease.

Conclusion

In summary, the new standard will affect lessee and lessor’s accounting in the following ways. Lessee will have an accounting model for all kinds of leases with exceptions put on low-value-assets and short-term lease contracts. Lessor accounting will remain unchanged but additional disclosure requirements will be required. The new standard maintains the definition of a lease but changes the guidance setting and how it should be applied. Before its implementation, companies will have to reorganize their house in order to cater for costs and understand the working of the new IFRS. The last part paper analyses these factors by using the Singapore lines as a sample study.

References

Christian, D., & Lüdenbach, N. (2013). IFRS essentials. Hoboken, N.J: Wiley.

Earnest and Young. (2016) A summary of IFRS 16 and its effects, May 2016.

Davies C., Tomlinson, R and Hughes, S. (2016) New lease accounting standard IFRS 16 – all change for lessees. Clifford Chance, 10 Upper Bank Street, London, E14 5JJ

Lavi, M. R. (2016). The impact of IFRS on industry.

International Accounting Standards Board. (2016). IFRS 16 leases.

Singapore Airlines. (2016). Strengthening a Position of Leadership. Annual Report 2015-016.

March 10, 2023
Category:

Business

Subcategory:

Management

Number of pages

9

Number of words

2287

Downloads:

46

Writer #

Rate:

4.8

Expertise Cost Accounting
Verified writer

I enjoyed every bit of working with Krypto for three business tasks that I needed to complete. Zero plagiarism and great sources that are always fresh. My professor loves the job! Recommended if you need to keep things unique!

Hire Writer

Use this essay example as a template for assignments, a source of information, and to borrow arguments and ideas for your paper. Remember, it is publicly available to other students and search engines, so direct copying may result in plagiarism.

Eliminate the stress of research and writing!

Hire one of our experts to create a completely original paper even in 3 hours!

Hire a Pro