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Conceptual changes to Lease Accounting

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The IASB and FASB jointly tackle the anomalies in lease accounting.

The International Accounting Standards Board (IASB) and the United States Financial Accounting Standards Board (FASB) released a second exposure draft on lease accounting in May 2013.

IAS 17 LEASES

IAS 17 Leases currently allows a company to classify its leases as either a finance lease or an operating lease, based on whether the lessor retains (in the case of an operating lease) or transfers (a finance lease) substantially all risks and rewards incidental to ownership of the asset. Under the existing accounting treatment of IAS 17, assets leased out under a finance lease are derecognised by the lessor and recognised by the lessee, whereas with an operating lease, the lease asset is kept as an asset by the lessor, and the lessee only recognises a lease expense with disclosure in the notes about the future lease payment obligations.

The question is: is the business of the entity truly reflected if this right to use an asset is not shown on the financial statements of the lessee? Just think about what is actually said with the way operating leases are accounted for now. Is it really to the benefit of the users of financial statements?

CONCEPTUAL FRAMEWORK

Although the Conceptual Framework is not an International Financial Reporting Standard (IFRS), it forms the foundation for the preparation and interpretation of financial statements. One of the purposes of the Conceptual Framework is that it assists users of financial statements in interpreting the information in those financial statements.

Currently the treatment of operating leases in IAS 17 Leases contradicts the definitions of assets and liabilities in the Conceptual Framework, preventing preparers of financial statements from providing information that faithfully represents the business, and therefore making it difficult for users to interpret the information correctly.

The objective of financial statements is to provide users (existing and potential investors, and lenders and other creditors) with useful information to assist them in making decisions. If the application of an IFRS does not give faithfully represented information which is relevant to enable users to see the real picture, it’s misleading them and missing the objective of financial reporting.

Useful information must be both relevant and a faithful representation of what it claims to represent. Information is relevant if it could influence the decisions users make. To be a faithful representation, information must be complete, neutral and free from error. The applicable characteristics for this discussion are completeness and neutrality.

Another enhancing characteristic that could be added is comparability – enabling users to compare financial statements between different periods and companies. The current standard for leases gives too much scope for omitting some of the relevant information – by allowing similar transactions to be treated in different ways, by arranging lease contracts in such a manner that a company achieves the financial position which they prefer, rather than showing the true picture.

When interpreting the definitions in the Conceptual Framework, care must be taken to consider the substance of the transaction and not automatically only its legal form. The definition of an asset is: a resource controlled by the entity, as a result of past events, from which future economic benefits are expected to flow to the entity.

A lease (finance lease or operating lease) meets this definition: a resource controlled by the entity (note: controlled does not mean owned) – the lease contract gives the lessee the right to use a part of the asset for a specified period to derive benefits; the past event would usually be the signing of a contract giving the right to use the asset from the lessor to the lessee, and it would be expected that future economic benefits will flow to the entity from the use of the asset. IAS 17 Leases gives the opportunity to lessees to account for assets (being the right to use the asset for their own benefit) as an expense, with no corresponding liability.

The definition of a liability is a present obligation of the entity, arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. As the lessee would enter into an agreement to obtain the right to use the asset in exchange for consideration (the past event), the non-cancellable period of the lease will result in a present obligation for the lessee.

To settle this obligation, economic benefits will flow from the entity. Under IAS 17 Leases, future lease payments for an operating lease are disclosed only in the notes to the financial statements (with no discounting to present values to take into account the term of the lease or the rate charged by the lessor). No liability is created on the statement of financial position, even though there is a present obligation to settle the lease payments in terms of the lease contract.

Therefore, by not recognising all assets and liabilities resulting from leases, all relevant information is not presented to the users of financial statements. The financial statements do not give them a faithful representation of what is happening in the business – creating a false picture for users, hiding transactions that actually are finance transactions. Users are expected to take the disclosed lease information to make their own adjustments – without having enough information to do so.

Ed/2010/6 Leases

In July 2006 the IASB and the FASB started on a new project to improve the accounting treatment of leases. During March 2009 a discussion paper (DP/2009/1) was released and the first exposure draft (ED) was released in 2010 (ED/2010/9), implying major changes to the accounting for leases by both the lessee and the lessor. After comments had been received, a revised exposure draft (ED/2013/6) was released on 16 May 2013. Going back to the basics of accounting, these changes should result in a better reflection of a company’s business than is currently the case.

The major change to accounting for leases proposed in the exposure draft will be for lessees to recognise a lease liability initially measured at the present value of the lease payments, and a corresponding asset (called a “right-of-use” asset). For type A leases (most leases where the asset is not property) there will be two expenses: the unwinding of the discount on the lease liability as an interest expense and the amortisation of the right-of-use asset on a straight-line basis. For type B leases (most leases where the asset is property) there will be one lease cost, consisting of the unwinding of the lease liability and the amortisation of the right-of-use asset.

These changes will give a more relevant and faithful representation of the financial statements to users, enabling entities to achieve the objective of financial reporting. When the final standard is released, we will have to assess the cost of implementation and the effect it will have on leasing as an industry.

Author: Sybil Smit CA(SA), MAcc (Computer Auditing), is Lecturer at the Department of Accounting, Stellenbosch University.