Proposed Changes To Lease Accounting And Implications For Financial Reporting

Discussion

Discuss About The Proposed Changes To Lease Accounting Under?

During the financial crisis, many organizations are not able to adjust to real economic situations while complying with current accounting requirements. Economic reality is not reflected by today’s accounting system. New standard for leases has been issued by International accounting standard boards that calls for the need of recognising the leases on the lessees’ balance sheet. The amount of leases is to be recognized as liabilities of leases that correspond with right of use of assets. Different decisions are taken with respect to measurement, classification, presentation and recognition of leases for both lessors and lessees that does not make the new standard fully converged. A dramatic change is presented to the balance sheet of lessees by the new leasing standard by updating accounting to align with certain changes in model of lessee and new revenue recognition standard (Bailey, 2013).

Significant efforts are not recognized under the current standard of lease as most of the lease transactions are off balance sheet. Organizations operating sector such as airline, shipping and retail segments have around three trillion euro’s worth of leases and record of same is not mentioned in the balance sheet and are labelled as operating leases. Recording leases value off balance sheet does not indicates that there will not be creating real liabilities. This makes them unable to quickly adjust to ongoing economic situation. Not recoding the leases in the balance sheets indicated that such organizations are maintaining lean balance sheets (Riley & Shortridge, 2013). However, leased liabilities recorded off balance sheets were quite higher than amount of total debt reported in their balance sheet. All this contributed to not reflecting underlying economic in a better way.

Operating leases is not featured in balance sheet of entities under current lease accounting and there is no representation of many liabilities and assets. Thousand worth of assets under agreement of operating lease that is nit depicted clearly in financial metrics lead to understatement of liabilities. This will not give real situation of organization and does not incorporate the ongoing economic scenario.

The off balance sheet of reporting entities under former accounting standard were 66 times greater than their total value of debts reported on balance sheet. In regard to this, there were critics for guidance on current lease accounting. Reason that criticized is the fact that current standard allowed the future lease payments and other leased assets to be excluded from balance sheets of reporting organization. Moreover, for similar economic transactions, there was considerably different accounting as they used budget line threshold.  Standards require virtual recognition of leased assets and payments that leads to presentation of deceptive balance sheets and all expenses related to lease were front loaded (Beckman, 2016). For the operating leases as per current standard, there is straight line expense and any increase in operating lease expenses are included and depreciation and amortization are included in the computation or measurement of profit. All such expenses are not accounted for or disclosed in balance sheets and in reality there are increased expense with increase in value of operating leases. Furthermore, under current leasing standard, there is no need to recognize the all leases in their balance sheet along with no obligations for future lease payments. Current lease accounting puts burden on organization for maintaining separate set of books for the purpose of covenant calculations (Cheng, 2015).  All this make look balance sheet in a better position and making it attractive in investor’s eyes. In reality, there are increased debt obligations and higher amount of off balance sheets liabilities.

Judgements and estimates

For the airline companies, under the current accounting standard there is no level paying filed between them. There exist lack of making comparison and Airline Company to look different from its competitors leases most of its airline fleets. While some other companies in airline industry borrows or take loan for buying most of its fleet. However, the real situation is that there exists much similarity between their financial obligations. This is the reason attributable to the fact that there is no level playing field between such organizations (DiSalvio & Dorata, 2014).

The reason for that the new accounting standard for lease will not be popular with everyone is due to the profit factor. Two different expenses would replace rent expenses under new accounting standard for lease. Depreciation expense on leased asset and interest expenses on leased liabilities and this might make figures of reported operating profit look better. However, the reported net profit after tax has the possibility of reduction in early years of lease. It is recognized by IASB that its new standard for leasing will be out to controversy as there will be disappearance of cosmetic accounting benefits of leasing. Furthermore, for updating to the criteria of new accounting standard, there will be involvement of additional cost to companies. Making standard effective would require organizations seeking lease to explain significant changes in their financial statement to stakeholders and investors (Lin & Graham, 2017).

The current lease standard has missing information regarding leasing and various techniques are used by investors to add back operating leases on balance sheets. Nonetheless, rough calculations are done for such adjustments that may be way off the mark. The adding back process cannot be done by all investors and many times organization structures their obligations for lease for their virtual presentation making balance sheet look better in investor’s eyes (James, 2016). The underlying economics will be better presented by recognizing the leases as liabilities and assets in the balance sheet. There will be better informed investment decisions by this new visibility and the introduction of new leasing standard will bring the main changes that would be useful for investors. This involves organization currently having large amount of leases off balance sheet would require to increase their liabilities and assets on balance sheet by making leases amount visible and leading to improve transparency of asset base and organization’s leverage. There will be balanced lease versus buy decision management as some important differences would be noticeable in the income statements. New standard is central to investors in financial reporting programme that highlights the importance of making informed investment decisions by building trust in capital market (Meyer, 2013).

As per the new accounting standards, organizations are required to do more than simply converting footnote disclosures relating to operating lease commitments to reflect lease liabilities and assets. Changes would be brought in the control, process, policies and system of information technology supporting lease accounting along with administration, procurement and taxation relating to lease due to the implementation of new accounting standard.  Negotiation of contracts involving leases leads to the consideration of metrics and financial statements implication (Mellado & Parte, 2017). Different departments across the company will be involved in this process.

Application of estimates and judgement is required as per the new standard and this can be explained with the help of an instance. Organizations are required to evaluate whether the definition of lease is meeting the arrangement calls for judgement requirements such as significant component of service. As compared to current standard, different accounting are required for treatments as per the revised lease definition. Judgement might require some other key decisions such as lease term and lease payments including the lease modifications accounting and evaluation of lease term. There will be increased scrutiny for judgement and estimates under new standard and this is attributable to the fact that for most of leases, the associated liabilities and assets will be reported in the balance sheets. Accounting at transition and post transition regarding leases has a different number of accounting policies involving the exemption of recognition for low value assets and short-term leases (February, 2016). There are certain relief from transition as mentioned in the new standard such as reducing the burden of implementation. Informed decisions would be facilitated as it is dependent upon to company to understand such options. In order for organizations to ensure consistent processes and policies concerning judgement and estimates made for lease accounting require them to update their manuals and policies and at the same time guiding and educating on new standard (Arrozio et al., 2016).

As per new standard, the present value of lease payments over the term of lease will be recognized by lessees on their balance sheet as lease liability.  Certain variable payments are excluded from lease payment and the terms that are reasonably certain of being exercised are included in lease term options. While negotiating the payment and terms of lease, needs might be reassessed by lessees. Smaller amount of lease liabilities would arise from shorter term of initial lease and compared to fixed payment, there is higher variable payments proportion. An organization needs to be acquainted with potential impact of new standard on financial statements when entering into new leases as per new lease standard.  From the perspective of presentation of financial statements of organization, the approached for minimizing the liabilities of leases can be advantageous. However, there are some business and economic risk associate with such approaches. While making any changes in lease contracts approaches, organizations should consider such changes in context of principal commercial requirements. For instance, it can be considered by organization for property plant to a lower liability of lease from shorter lease term against the longer-term access security. Moreover, other hesitant that can arise of side of lessors is taking additional risks related with shorter lease term and making variable payments. However, results of accounting should not form the basis of taking economic decisions and they needs to be acquainted with consequences of accounting relating to decisions of their business.

Now, looking at metrics and financial statements of lessees, there will be gross up of balance sheet as per new standard. Compared with current accounting, the new standard would result in worsening of return on assets and debt ratios. Moreover, there can also be impact on certain regulatory ratios. Potential impact on financial statements and metric of company needs to be assessed by organization and they should also evaluate the ways it would affect the financial performance and position as perceived by stakeholders. The implication of new standards on the financial statements needs to provide education to internal as well as external stakeholders.  During the transition period as per the new lease accounting standard, the needs to manage the communication of key performance indicators to stakeholders needs to be anticipated by company. Organizations are required to identify any changes that will be brought into the arrangement of debts and compensation of employees under the new standard. It might he required by companies to evaluate the arrangement of existing debt and seeking continued use for current lease accounting by negotiating with creditors (Barone et al.,  2014).

There will be additional considerations for tax as per the new lease standard. It involves understanding the alteration in existing position of tax due to changes in lease accounting, tracking of differences in tax payment and making adjustments to deferred taxes. For reflecting the new requirement standard, organization is required to understand specific tax jurisdictions (Öztürk & Serçemeli, 2016).

Conclusion:

Much needed transparency will be brought by the adoption of new lease accounting standard on liabilities and assets of organization. Comparability between organization borrowing to buy and using lease would be facilitated by the implementation of nee standard. There will be inevitable arise in questions of application and interpretation relating to new standard implications. Financial metrics of organization will considerably change with the implementation of new standard that involves change in asset turnover, current ratio, operating profit, earnings before interest and taxation and debt to equity ratio. Debt covenants and cost of borrowing will be significantly affected by improved visibility of lease obligations. Nonetheless, the benefits associated with updating will outweigh the costs incurred in implementation of standard.

References List:

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Bohušová, H. (2015). Is Capitalization of Operating Lease Way to Increase of Comparability of Financial Statements Prepared in Accordance with IFRS and US GAAP?. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 63(2), 507-514.

Cheng, J. (2015). Small and Medium Sized Entities Management’s Perspective on Principles-Based Accounting Standards on Lease Accounting.

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Lin, K. C., & Graham, R. C. (2017). How Will the New Lease Accounting Standard Affect the Relevance of Lease Asset Accounting?.

Mellado, L., & Parte, L. (2017). Determinants of corporate lobbying intensity in the lease standard-setting process. Revista de Contabilidad, 20(2), 131-142.

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