Types of Lease Agreements
The current report intends to evaluate the concept of lease agreements and their impact on financial reports by providing a description of operating and financial leases. For simplifying this report further, Woolworths Limited is selected as the organisation operating in the Australian supermarket along with depicting its leasing procedure. In addition, the paper covers short-term as well as long-term effects of the changes to reporting for leases. Finally, the report would shed light on the former and new accounting standards for leases based on the provided case study.
In the words of Bamber & McMeeking (2016), lease agreements are contractual agreements, which need a user to pay for using an asset to the owner of that asset. The most common types of assets that are used in leasing agreements in the Australian business organisations comprise of buildings, property, vehicles, business and industrial equipment.
Lease agreements are of two types, which include operating lease and financial lease. Operating lease is the lease where the risks and rewards associated with the ownership of the asset stay with the lessor for the leased asset. Financial lease could be defined as the lease, in which the rewards and risks related to asset ownership are passed over to the lessee. The treatment of operating lease is like rent, which implies that lease payments are considered as operating expenses and they are not included in the statement of financial position (Benson et al., 2015). On the other hand, the treatment of financial lease is like loan, in which the lessee considers the asset ownership and thus, the asset is disclosed in the balance sheet statement of the concerned organisation.
Due to financial lease, the asset and liability values tend to increase in comparison to operating lease. In the initial years of the life of an asset, there is lower net income in financial lease, as depreciation expense is higher. However, with the passage of time, there would be decline in depreciation expense and as a result; the net income is greater under financial lease compared to operating lease (Dagwell, Wines & Lambert, 2015). In addition, under financial lease, the operating income would be greater, since interest expense is not taken into account to arrive at the operating income. However, in case of operating lease, operating income would be minimised, since rent expense is included for computing operating income.
In financial lease, there would be increase in operating cash flow, since only interest expense is considered in the form of operating outflow. However, in operating lease, both principal amount and interest amount are included as operating outflows. There would be reduction in financing cash flows under financial lease, since repayment of principal is considered in the form of financing outflow. In opposition, there is no such record under operating lease.
Leasing Procedure of Woolworths Limited
Woolworths Limited is a leading retailer in the Australian supermarket operating mainly in Australia and New Zealand and in terms of revenue, it is the second largest organisation placed after its fierce competitor, Wesfarmers Limited. The major operations of the organisation comprise of supermarkets, liquor retailing, pubs, hotels and discount department stores. However, it has incurred a significant loss amounting to $1.235 billion in 2016, which is the largest among the previous 20 years. Such loss is due to the write-downs of $2 billion of the failed Masters Business and losses incurred in the Big W business (Woolworthsgroup.com.au, 2018).
According to the annual report of Woolworths Limited in 2017, the operating lease expense in the year 2017 has been $2,034.3 million, which was $1,963.9 million in 2016.
The organisation has realised its operating lease payments in the form of expense on straight-line basis over the term of the lease. The rise in fixed rates to lease rental payments and exclusion of contingent or index-based rental rises are realised on straight-line basis over the term of the lease. As a result, it leads to the formation of an asset or liability for the difference between lease expense and amount incurred for accounting on straight-line basis ((Carey, Potter & Tanewski, 2014). The incentives of operating lease are realised initially in the form of liability and they are realised as portion of the lease expense based on straight-line method over the lease term.
As observed from the latest annual report of Woolworths Limited, the financial lease has amounted to $0.1 million in 2017, which was $0.4 in 2016 in case of current borrowings. On the other hand, the financial lease for non-current borrowings of the organisation has been $2.3 million in 2017, which was $2.9 million in 2016. The financial leases are classified on the term that all the risks and rewards of asset ownership stay with the lessee.
According to AASB 16, the leases would be categorised depending on their nature as either operating leases not realised in the balance sheet statement or financial leases realised in the income statement (Aasb.gov.au, 2018). In case of Woolworths, for accounting operating leases in the form of lessee, there would be recognition of right-of-use (ROU) asset and related lease liability on the balance sheet statement. There would be realisation of interest expense on lease liabilities and depreciation charge for the ROU assets. However, the role of the lessor for the organisation would stay unchanged (Woolworthsgroup.com.au, 2018).
Effects of Reporting Changes on Leases
AASB 16 requires recognition of ROU assets and associated lease liabilities for various commitments related to operating lease of an organisation. It has been identified from the annual report that Woolworths Limited has $24,438.8 million in the form of non-cancellable undiscounted commitments of operating lease. Such commitments have direct linkage with its retail premises, centres of distribution, support offices and warehouse facilities that are to be realised in the form of ROU assets and related lease liabilities (Dakis, 2016).
Once AASB 16 comes into effect on 1st January 2019, it would have considerable effect on the financial statements and gearing ratios of Woolworths Limited both in short-run and long-run. Due to the presence of off-balance sheet lease, the application of AASB 16 would increase the profit before tax of Woolworths. This is because the presentation of implicit interest would be made in the lease payments for leases related to former off-balance sheet in the form of finance costs (AASB, 2014). In opposition, as per the old standard, the off-balance sheet expenses would be incorporated in the form of operating expenses.
On the other hand, it is necessary to capitalise operating leases for complying with the requirements of AASB 16. As a result, when Woolworths capitalises its operating leases, there would be increase in asset as well as liability. However, it is to be borne in mind that there is linearity in asset amortisation, while no such linearity is inherent in liabilities. As a result, the liabilities increase rapidly in contrast to assets implying greater leverage (Henderson et al., 2015). Hence, under AASB 16, there would be increases in debt ratio and debt-to-equity ratio, while equity ratio would decline. However, the new standard would not have any effect on the cash flow statement of Woolworths Limited, as inflow and drainage of cash would remain identical between both lease parties.
As Woolworths operates in the Australian supermarket, it falls under the retail industry. It has been identified that the retailers use real estate leases for their stores (Hoggett et al., 2014). The impact would be severe on the Australian retail industry after the implementation of AASB 16, which is summarised briefly as follows:
Renewal options:
One of the core businesses of a retailer is leasing real estate. As a result, considerable judgement is needed for ascertaining and re-evaluating at the time the retailer has an economic incentive of renewing retail lease location (Holland, 2016).
Former and New Accounting Standards for Leases
Relationship between rate/index and variable payments:
It is necessary for the retailers to implement systems for projecting and re-gauging variable payments associated with an index at the spot rate for each reporting year like consumer price index.
Segregation of leasing and non-leasing elements:
It would become mandatory for the retailers to segregate service charges. The service charges could be in the form of marketing, administration and utilities (Jamburia & Lankeviciute, 2015). The segregation needs to be made from lease components with the landlords like large retail outlets and leases pertaining to shop-in-shop.
The accounting variations have impact on nearly one-half of the organisations following IFRS or US GAAP. The total amount of leased commitments and assets of these organisations stands at around $3.3 million and 85% of them are not mentioned in the balance sheet statement, since considerations are made as operating leases (Joubert, Garvie & Parle, 2017). As a result, the investors could not make rightful, consistent and comparable estimations. This denotes the failure of the previous accounting standard in signifying economic reality.
There is development of real liabilities despite the fact that there is no recording of operating leases in the balance sheet statement. Thus, during economic downturn, few popular retail firms were insolvent, as they could not advance rapidly to match the revised economic reality. Moreover, considerations commitments could be observed for long-term operating leases; however, there was deceptive leaning in the balance sheet statement. Hence, the lease liabilities had been 66 times more than the debt amounts reported in balance sheet statements.
Comparability was incredibly low in the previous accounting system for leasing. In the airline sector, operating leases are mostly inherent and disclosures are not made in the balance sheet statement. Thus, an airline leasing aircraft fleet does not match with the competitors buying all fleets; however, similarity could be observed in their financial obligations (Wong, Wong & Jeter, 2016). This denotes that level playing field is not present in the aviation industry. The new standard would account leases as assets, while they would be recorded as liabilities on the part of the lessees and this would helping in solving the issue.
Since AASB is a new leasing standard, the effect would be on more than half of the listed firms, since changes might result in debates and warnings in terms of adverse economic conditions and costs related to system changes (Wong & Joshi, 2015). The commercial effects would be inherent as well, if such changes are implemented.
For instance, the various covenants of banking and contractual agreements related to the financial statements like profit targets for providing bonus payments are required to make revisions before the enforcement of the standard. In addition, all business departments in an organisation are needed to understand the impact of changes such as finance, human resource, asset procurement and others (Xu, Davidson & Cheong, 2017). Due to these reasons, it would become difficult to gain popularity for AASB 16.
Conclusion:
Based on the above discussion, it could be found that Woolworths Limited has realised its operating lease payments in the form of expense on straight-line basis over the term of the lease. The rise in fixed rates to lease rental payments and exclusion of contingent or index-based rental rises are realised on straight-line basis over the term of the lease. Once AASB 16 comes into effect on 1st January 2019, it would have considerable effect on the financial statements and gearing ratios of Woolworths Limited both in short-run and long-run. Due to the presence of off-balance sheet lease, the application of AASB 16 would increase the profit before tax of Woolworths. Finally, it has been evaluated that AASB 16 would result in global increase in debt and EBITDA in all the industries; however, the impact would be severe on the retail sector.
References:
AASB, C. A. S. (2014). Business Combinations. Disclosure, 66, 77.
Aasb.gov.au. (2018). Retrieved 28 April 2018, from https://www.aasb.gov.au/admin/file/content105/c9/AASB16_02-16.pdf
Bamber, M., & McMeeking, K. (2016). An examination of international accounting standard-setting due process and the implications for legitimacy. The British Accounting Review, 48(1), 59-73.
Benson, K., Clarkson, P. M., Smith, T., & Tutticci, I. (2015). A review of accounting research in the Asia Pacific region. Australian Journal of Management, 40(1), 36-88.
Carey, P., Potter, B., & Tanewski, G. (2014). AASB Research Report No.
Dagwell, R., Wines, G., & Lambert, C. (2015). Corporate accounting in Australia. Pearson Higher Education AU.
Dakis, G. S. (2016). Upcoming changes to contributions and leasing standards. Governance Directions, 68(2), 99.
Henderson, S., Peirson, G., Herbohn, K., & Howieson, B. (2015). Issues in financial accounting. Pearson Higher Education AU.
Hoggett, J., Edwards, L., Medlin, J., Chalmers, K., Hellmann, A., Beattie, C., & Maxfield, J. (2014). ACCOUNTING 9E. Wiley.
Holland, D. (2016). Simplifying income recognition for not-for-profit entities. Governance Directions, 68(11), 666.
Jamburia, M., & Lankeviciute, V. (2015). Political Influences on the IASB Accounting Standard-Setting: The Case of the Leases Standard.
Joubert, M., Garvie, L., & Parle, G. (2017). Implications of the New Accounting Standard for Leases AASB 16 (IFRS 16) with the Inclusion of Operating Leases in the Balance Sheet. The Journal of New Business Ideas & Trends, 15(2), 1-11.
Wong, J., Wong, N., & Jeter, D. C. (2016). The Economics of Accounting for Property Leases. Accounting Horizons, 30(2), 239-254.
Wong, K., & Joshi, M. (2015). The impact of lease capitalisation on financial statements and key ratios: Evidence from Australia. Australasian Accounting Business & Finance Journal, 9(3), 27.
Woolworthsgroup.com.au. (2018). Retrieved 28 April 2018, from https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf
Xu, W., Davidson, R. A., & Cheong, C. S. (2017). Converting financial statements: operating to capitalised leases. Pacific Accounting Review, 29(1), 34-54.
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