Current Developments In Lease Accounting And How Firms Should Respond

Objectives of Report

1.1. Overview and Background

The IASB published a new standard for leases (AASB 16) in January 2016 which was to take effect in January 2019 (AASB, 2004, n.d.). This standard requires lessees to report all leases on the balance sheet. The purpose of this report is to compile the current developments in lease accounting and how firms should respond to the challenges in adopting the new standard.

1.2. Objectives of the Report

The primary objective of this report is to analyze the impact of this new accounting standard on leases to the clients and the business.  Other aims and objectives of this report include merits and demerits of the new accounting lease standard, how the AASB 16 should be communicated to the clients, how the staff of the company should be trained with regards to the new standard, whether the corporation should have a specialist group that would help deal with these issues on accounting standards matters and a recommendation on whether the organization should have a separate lobby group that would deal with these changes in accounting standards and any other current developments on matters related to accounting standards (AASB, 2015, n.d.).

1.3. Main Impact

According to the new accounting standard on leases (AASB 16), a lessee is supposed to recognize all his or her leases on the balance sheet. This standard would have a great impact on the companies that use leasing or rental as a way to acquire assets. According to the previous standard (AASB 117), the lessee was required to recognize any lease transaction as a finance or an operating lease (AASB, 2013, n.d.). Additionally, using this new standard, lessees would be provided with flexibility which would help them address any issues related to the risk in the residual value of their acquired asset as well as its obsolescence. Furthermore, this new standard will affect the performance metrics and financial ratios used by companies such as current ratio, interest cover, EBIT, net income, ROCE, and so forth. Ideally, this is because as companies acquire assets through leasing, they would have to take a loan in order to acquire that asset (Ahmed and Alam, 2012, p.110). As a result, their gearing ratios would increase which would translate to a decline in capital ratios, thus enabling the balance sheet to grow. For this reason, corporations need to keep abreast of these current developments in the accounting standard.

1.4.   The scope of the Report

Impact of New Accounting Standard on Leases

This report will cover all matters relating to the transfer of the right of use an asset to another party at a cost for a specific period of time as prescribed by the standard (AASB 16). However, this report would not cover any license of intellectual property granted by the lessor, the rights of licensing agreements such as films, plays, videos, patents, manuscripts and copyrights, the leases of any biological assets, and the exploration of minerals and other resources such as natural gas and crude oil (Brown, 2006, p.87).

1.5.   Exemptions made if any

Besides these, the lessees of intangible assets such as goodwill are exempted from the new accounting standard (AASB 16). Other exemptions as per AASB 16 (para 22-49) include short-term leases and leases whose assets are of low value (CPA Australia, 2016, n.d.).

2.Key Considerations and Definitions

2.1.   Defining a Lease

AASB 16 defines a lease as a “contractual agreement where a lessee (buyer) agrees to pay a certain amount to the lessor (owner of the asset) for the transfer of the right of use of the asset”. In other words, a lease can be described as a contract between two parties where one party agrees to pay a specific amount in order to rent the asset of the other party for use within a specific duration after which it is returned to the owner (Dakis, 2016, p. 99).

2.2.   Characteristics of a Lease Agreement

A lease may have four main characteristics, that is, a lease may be long-term or short-term depending on the purpose of use of the asset, the lessee has to pay a consideration known as the lease payment to lessor in order to be granted the right of use of the asset of the lessor, the lessee is required to pay the consideration for using the asset of the lessor in instalments and not as a lumpsum and it may constitute a mutually unperformed contract at its inception since during the inception of the lease, the lessee and the lessor come together in order to make a contractual agreement that is yet to be performed (Deloitte, 2016, n.d.).

2.3.   Meaning and Characteristics of a Lease Term

A lease term may be defined as a fixed term whereby the lessor gives the lessee the right to use his or her asset for a fixed duration which is non-cancellable until the fixed duration is over (De Martino, 2011, p.366). Its characteristics, therefore, are that it has a fixed duration, it is non-cancellable and it is legally binding which means that it is a legal contractual agreement between the lessor and lessee which must not be broken until the period expires (Georgiou, 2010, p.104).

AASB 16 Definition of a Lease

3.What is the New Model and how is it different from the old standard?

The AASB 16 has the same elements or treatment of leases like the AASB 117. However, it contains improved transparency on capital employed and financial leverage (level of debt) since a lessee is supposed to recognize all his or her leases in the balance sheet. Additionally, the lease was grouped or classified as either operating or finance lease in the old AASB 117 standard (Gross et al., 2014, p.760). However, in this new standard (AASB 16), a lease is just a lease and there is no distinction brought forth.

4. Accounting Treatment

4.1. Accounting Treatment for Lessors

There is no huge difference for the accounting treatment of lessors between AASB 117 and AASB 16. Ideally, the lessor is still supposed to classify whether the lease is a finance or operating lease. Here, finance leases should be accounted for by being recognized as a net investment in the fixed assets section of the balance sheet (Hung and Subramanyam, 2007, p.624). Specifically, this net investment can be computed by finding the sum of the residual value to the lessor and the present value of future lease payments.  Despite this, there is no change in the accounting treatment of operating leases by the lessor since the lessor is required to recognize this lease on the balance sheet and any other income attributable to it as an accrued income in the current assets segment of the statement of financial position (Joubert et al., 2017, p.2).

4.2.Accounting Treatment for Lessees

The main difference between the AASB 117 and the AASB 16 standard occurs in the treatment of leases for the lessees. Here, the lease would be recognized using the right of use instead of the previous risk and reward recognition by AASB 117 (Kusano et al., 2016, p.74). There will be two steps of recognizing leases by the AASB 16 standard, that is, the initial measurement and the subsequent measurements. The initial measurement would include the initial cost of the lease liability, any lease payments fewer incentives received for engaging in the lease and the estimated costs that would be incurred for dismantling the leased asset. Here, the lease liability would be the present value of lease payments which would be discounted using the interest rate that has been applied on the lease or the borrowing rate of the lessee whichever is available (Loyeung et al., 2010, n.d.).

Treatment of Leases for Lessor and Lessee

For the subsequent measurements, the cost model or the fair value model can be used. Using the cost model, the lessee can determine the amount to recognize on the balance sheet by taking the cost of the lease minus the depreciation and impairment losses. Here, the lease liability would be computed as interest plus the lease payments. Using the fair value model, on the other hand, the lessee would have to refer to AASB 140 (investment property) or AASB 116 (property, plant and equipment) whichever has been adopted by the lessor in order to compute the cost of the lease (Loyeung et al., 2011, n.d.). Here, the lease liability would be calculated as the changes in the lease liability in comparison with the carrying value of the leased asset.

4.3. Other leasing related topics

Other leasing related topics that have been considered in the new AASB 16 standard include peppercorn leases and sale and leaseback.

According to AASB 1058 (income for not for profits), an asset should be recognized t fair value only when the consideration or lease payment for that asset is less than the fair value of that asset in the market (Mellado and Parte, 2017, p.132). This means any right to use of an asset which falls under peppercorn leases should be recognized at fair value and this should be incorporated in the new accounting lease standard (AASB 16). However, if a not for profit organization enters into a lease agreement where the lease payments are below the market value, then it should be measured at fair value in accordance with AASB 13 (Fair value measurement), a lease liability should be recognized in the balance sheet in accordance with AASB 16 (Accounting for Leases) and any difference between the carrying amount of the asset and its lease liability should be recognized as an income in the statement of financial performance (AASB 1058 para 10).

This arises when a lessee sells the leased asset to another entity, thus leasing it back from the lessor. Here, the company ought to first assess whether the transfer of the asset is a sale by incorporating AASB 15 (revenue under contract with customers). If it is a sale, the lessor should recognize a disposal of the transfer of rights by measuring the right of use of the asset against its carrying amount by the lessee (AASB 15 para 100(a)), measuring the lease liability using the present value of future lease payments any gain or loss of the rights transferred instead of the gain or loss of the total leased asset as initially recognized by AASB 117 (para 100(a)). The lessor, on the other hand, shall recognize the asset at fair value. If it is not at fair value, the lessor must make appropriate adjustments by determining whether the cost of the leased asset is below or above market (Pawsey, 2008, n.d.). If it is below market, the lease liability would be treated as prepayments of the lease payments while if it is above market, the lease liability would be treated as an additional financing provided by the lessor to the lessee.

If the transfer is not a sale, the lessee shall continue recognizing it as an asset and recognize the lease liability by applying AASB 9 (financial instruments). The lessor, on the other hand, shall not recognize the transferred asset and shall only recognize the financial asset equivalent to the lease payments (AASB 9).

5. Transitional Requirements

5.1.Transitional requirements for Lessors

Relief is provided to a lessee when he or she is transiting from AASB 117 to AASB 16. On transition, the lessee may have two options, that is, adopting the AASB 16 in full or partially only at the implementation date (Tang, 2008, n.d.). If the specialist team that is helping the client to transit uses the first option, the team is required to adjust the current year using prior year estimates (AASB 108 para 22) and restate the opening retained earnings using the estimates. However, if the specialist adopts the second option, the team would be required to adjust the current year using AASB 16, to restate the beginning retained earnings and not to restate any estimates relating to the lease.

6. Impact of the New Standard

The new standard would have certain benefits and costs which would affect the financial statements as well as the financial performance of the organization (Thornton, 2016, n.d.).

6.1. Benefits and Advantages of the New Standard

Two key benefits would be realized by incorporating the new AASB 16 standard which includes quality financial reporting and comparability. First, using the AASB 16 would enable financial analysts and investors to estimate any off-balance sheet leases. As a result, being able to know the assets that a company controls would enable them to incorporate a faithful representation of the financial performance and position (Treasury Department of New South Wales, 2017, n.d.). Additionally, it would create greater transparency of the capital employed as well as the financial leverage of the firm. Second, using AASB 16 would enable the business to compare the cost of the leases and the lease liability between the periods.

6.2.Costs and Disadvantages of the new standard

Despite the benefits of the new standard, it would have some disadvantages which comprise changes to the information system, training, determination of the discount rate to be used by the company, incorporating the new standard to identify a lease, and the separation of the lease and the services within the contractual arrangement. First, the company would have to make some changes to its information system in order to adapt to the new AASB 16 accounting standard. Second, the staff of the business would have to be trained on how to incorporate the new AASB 16 standard (Xu et al., 2017, p.35). Third, the company would need to ascertain the discount rate or the interest rate that they would use on the lease which would help them in the computation of the annual lease payments. Fourth, using the new standard would require the company to identify whether it is a lease or not based on the definition of a lease under AASB 16 (Appendix A). If it is a lease, then it should be recognized accordingly. However, if it is not a lease, the company should just recognize it under PPE. Lastly, the leased asset and lease service should be separated where the leased asset should be recognized on the balance sheet.

Relief for Transitioning from AASB 117 to AASB 16

6.3.Effects on Financial Statements

This new accounting standard AASB 16 would have six effects on the financial statements which are detailed below.

No.	Statement	Effect
1	Balance sheet	Under AASB 16, if a lease occurs, the company would realize an increase in lease assets as well as an increase in financial liabilities which shall be recognized in the balance sheet.
2	Balance sheet	Consequently, when a lease occurs, the lessee would recognize a decline in equity since the carrying value of the lease asset is likely to decline more than that of lease liabilities.
3	Income statement	Subsequently, when the lease occurs, the company would realize an increase in earnings before interest tax, depreciation and amortisation (EBITDA). This is because the standard would not be classifying leases as either operating or financing and thus the operating lease costs would not be included in the income statement.
4	Income statement	Furthermore, when a lease occurs, the company would realize an increase or a decrease in profit before tax (PBT) depending on the lease portfolio, that is, when the interest expense is higher in prior years, the firm would realize an increase in PBT whereas if they are lower in prior years, the firm would realize a decline in PBT.
5	Cash flow statement	Moreover, a lease under the new accounting standard AASB 16 would cause an increase in cash flow from operating activities and a decline in cash flow from financing activities since the interest from the lease payments would be considered as cash outflows from the financing activities.
6	Cash flow statement	However, it is expected to cause no change in total cash flow since an incline in cash flow from operating activities and a decline in cash flow from financing activities would have no effect in the long-run.

 6.4. Effects on the financial performance of the company

The effect of the new accounting standard on the financial performance of the firm would be measured using the financial ratios, that is solvency, liquidity, and profitability. First, when a lease occurs, the lessor would be taking the asset on loan. Therefore, this would cause an increase in gearing due to an incline in financial liabilities (Wines et al., 2007, p.863). However, the interest coverage ratio would decline which would cause solvency problems for the company. Second, a lease would cause a reduction in current ratio due to an increase in current liabilities and it would cause no change in net cash flow. Third, a lease would cause a decrease in asset turnover, a decline in EBIT an increase or decrease in profit or loss and EPS depending on the features of the lease and the P & L respectively.

7. Recommendations and Suggestions

7.1. Arguments for and against the creation of the specialist team

The accounting firm should create a specialist team since it would help clients transit to the new accounting standard (AASB 16) from the old one (AASB 117). However, creating a specialist team would result in an increase in costs to the company since they would have to be paid (Xu et al., 2017, p.36).

7.2. Arguments for and against the new standard

The new standard is advantageous since it has brought about transparency on capital employed and financial leverage for the company. However, using this new accounting standard would make the company change on its information system and train its staff, thus resulting into additional costs for the firm (Wines et al., 2007, p.864).

7.3.Recommendations for and against the creation of a special lobbying team to ascertain any changes and developments in the future

The company should create a special lobby team since it would help them keep abreast of future changes and developments in accounting standards. Besides, it would help them cope or transit effectively. However, they would have to budget for the salaries of the special lobbying team, thus more costs to the business (Xu et al., 2017, p.37).

7.4.Recommendations on the training of the staff and managing client queries

To train staff, I would advise the company to organize seminars and workshops in relation to the new accounting standard. Additionally, they can manage client queries by setting up a specialist team within the company despite the increase in costs.

7.5.Other Recommendations and Suggestions

Other recommendations would be to enhance good project governance within the company which would enable them to implement this new standard effectively and manage any resistance to change from AASB 117 to AASB 16.

8.Summary and Conclusions

It can be concluded that the new accounting standard would bring in increased quality, transparency, comparability and consistency. The above analysis shows that the new accounting standard would have a significant impact on the lessees. It is expected that companies with off-balance leases would be the most affected by this new standard.

9. Presentation for the Client

The client would be required to present the leased asset and the lease liability in the balance sheet, the interest expense on the lease liability and the depreciation charge on the income statement and the interest expense portion of the lease payments in the cash flow statement as an operating activity (PWC, 2016).

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