Changes in Lease Accounting Classification and Treatment
The international financial reporting board has changed the concept and classification of the term “lease” effective from 1st January 2019. It has changed the whole perspective and the treatment of leased assets in the financial statement. Previously there were two types of lease, one is operating lease and another is financial lease but from due to newly announced IFRS 16, the whole classification of lease has been changed. Now, there is only existence of operating lease. Operating lease is now classified as service being provided by the person executing lease contract or person giving assets on lease. The lessee executing operating lease contract will be termed as service provider and operating lease will be treated as service to the organization.
This standard will act as restriction to those people who tries to hide their liability with the help of operating lease. In other words, companies who involved in understating their liabilities will no longer be able to understate their liability i.e. more transparency in financial statements. (Joubert, Garvie, & Parle, 2017).
International accounting standards committee has issued the new International Financial reporting standard 16 for smoothing the accounting treatment of Lease to maintain uniform treatment and disclosure requirement between different interested peoples. The objective of newly introduced IFRS is to provide mechanism to represents lease transactions faithfully and to measure uncertain cash flows from lease contract. IFRS 16 has introduced single lease accounting model by abolishing the concept of operating lease. A lease has to recognize all the assets and liabilities arising due to lease contract having a life more than 12 months. The new IFRS 16 has replaced international accounting standard 17 (IAS 17), Standard interpretation committee 15 and 27 (SIC 15 & 27) and international financial reporting committee standard 4 (IFRIC 4) and provides the principles for the recognition, measurement, presentation and disclosure of lease.
The concept and scope of IFRS 16 is generally similar to the IAS 17. It includes those contracts in which the right of use of asset is transferred to another person for a period more than 12 months in return of consideration. This standard does not apply to the companies engaged in the business of letting intellectual property rights, biological assets, minerals, oil, natural gas and similar natural resources.
The new amended IFRS 16 will come into effect in the financial year commencing from 1 January 2015 with full retrospective approach or modified retrospective approach.
Impact of IFRS 16 on Valuation of Lease Liability
The new amended standard is only related to the business of lease. Therefore, the overall effect of the standard is mostly on the lessee and the lessor. The effect of changes in IFRS 16 can be summarized below:
- Effect on lessee:lessee will no longer able to treat the operating lease as an item of profit & loss account. After such changes, the lessee will have to reorganize all lease as an item of balance sheet. This will result in changes in financial ratios like liquidity ratio, current ratio, turnover to total assets ratio, Earning per share, credit rating, Earning before interest and tax, and borrowing costs of the company. The companies engaged in the leasing of heavy machinery or plant or property, will be greatly effected by such changes in the IFRS 16. The whole items of such as assets and liabilities is going to change accordingly. The balance sheet of the lessee will now state increase value and the liability side will show more debt burden on the company. This will affect investor’s perspective regarding business in the business of the company. (Morales & Zamora, 2018)
- Effect on Lessor: lessor will now renegotiate and restructure existing and future lease payments with lessee. The new changes will affect significantly the accounting process of lessor but the main effect of such changes will be mainly on the lease terms and structure of the lease term. (Monson, 2001)
With the introduction of new IFRS, the whole treatment regarding lease has been changed. The concept of operating lease has no place in the new standard. IFRS 16 do not differentiate the term financial lease and operating lease. In other words, operating lease and finance lease both are same under new regime. This will lead to reduction in the borrowing costs of the company, as the lessor will not debit the extra amount paid as interest for operating lease in its profit & loss account but will account for the depreciation element for such leased assets. Similarly valuation of lease liability will be affected by the IFRS 16. Valuation of lease will now be similar to the valuation of loans based on the lease term/ loan term by adopting present value approach with the proper discounting rate. The underlying discounting rate should be either the company’s cost of capital or incremental cost of the borrowing. The valuation of lease liability will be affected by the lease terms, period of lease and the nature of lease assets. (James, 2016)
The new amended standard has a full retrospective approach or modified retrospective approach for accounting of existing lease agreements between lessor and lessee. In full retrospective approach, the lessee has to make changes regarding treatment of leased assets in its upcoming financial statements as well as financial statements of previous years. This will result into the restating earnings of the company with the material effect on the balance sheet total. The company has to make changes in its earlier comparative financial statements.
In the modified retrospective approach, lessee has to apply changes in the balance sheet from the effective date of change as prescribed in the IFRS 16. The corresponding cumulative changes will now be shown as adjustment in the equity in the balance sheet. In it, the lessee has to make changes in its current reporting cycle with the proper reporting of the cumulative effect on the previous leased agreements. The lessee will now recognize previous operating lease as a lease liability in their balance sheet. The recognition shall be based on the present value method discounted with the incremental borrowing rate at the date of initial application.
Retrospective and Modified Retrospective Approaches for Accounting of Existing Lease Agreements
Conclusion:
From the above discussion, it can be concluded that the amendment in IFRS 16 will prohibit window dressing in the financial statements by the companies to understate their liability to attract potential investors. Above-mentioned changes will result in more transparent disclosure of financial statement with the significant impact on the valuation method used in determining the obligation of the lessor towards the lessee. (Man & Ciurea, 2016)
The exposure enumerates treatment of sale proceeds arising due to sale of scrap and other items produced during the process of making the property, plant and equipment ready for use in the production process. It recommends the recognition of revenue as an item of Profit and loss account earned during the phase of making the asset fit for use.
In IAS 16, any revenue arising from the selling or disposing items produced or scraps generated during the period of making the assets available for use or during the testing period of such asset should be reduced from the cost of such asset. Hence, previously if an item of revenue, which is the result of further research and developments in the said assets, will be deducted from the value of such assets. It is widely accepted by different accounting bodies of the world.
The proposed amendment in IAS 16 states that any revenue which is incidental to or is the result of any process or research making the asset available for use in the operation, should be shown in the revenue statement as an item of revenue instead of deducting it from the value of the said asset. In other words, this amendment prohibits organization to deduct sales process from the cost of the assets before its intended use of operation. (Bozzolan, Laghi and Mattei, 2016)
The FRSC committee has made his comment in the agreement with said proposed amendment. In the comment, the reasons of such agreement has been mentioned below:
- The said amendment is in line with the conceptual framework of financial reporting.
- The definition of income is itself includes the economic benefit arising in an accounting period as a result of inflows from assets or any appreciation in the value of assets or decrease of liabilities. Based on the definition of income, sales revenue generated by disposing or selling the items produced while bringing such asset available for use, should be recognize as an item of revenue in the profit or loss account and should not deducted from the value of said asset.
However, the FRSC committee has pointed the difficulties, which may arise if the said amendment will come into effect such as determining the relevant costs associated with sold items. It is quite difficult and time taking task to allocate costs that are incidental or incremental to such revenue generated. For this purpose, a guidance note should be provided. The FRSC committee has also pointed the issue of when property, plant and equipment is to be recognized as available for use. It recommends board to issue guidance note clarifying the term “available for use” in relation to said property, plant and equipment.
Proposed Amendments in IAS 16 for Revenue Recognition
The China accounting standards committee is in disagreement with the proposed amendment in IAS 16 i.e. prohibiting the deduction of sales proceeds of scraps or items generated in the process making any asset available for use in operation. Followings are the reasons for such disagreement has been mentioned below:
- Any revenue generated by selling items or scrap during the process of making the asset available for use is the compensation towards the cost incurred during the testing period. If the cost that is incurred in the process of making asset available for use, will be the part of total cost of the asset then any revenue generated during such process will be deducted from the cost of such assets.
- The nature of revenue generated during the testing and quality checking process is different from the revenue generated during ordinary course of business by selling outputs. The intention behind the process of testing or quality checking is to insure the availability of the asset for use in operation and it is the part of the construction activity but not to generate the revenue from selling such item or scrap. It is incidental to the construction process. Therefore, the treatment of two different kinds of proceeds in same way is not justifiable and will affect the importance of revenue statement.
- The cost associated with the revenue earned by selling waste or scrap or inputs is quite difficult and it can not measured properly. The depreciation cost associated with such asset is not be allocated to the items because the provision of deprecation will only be applicable after the said is being available for normal use. Therefore, such revenue without proper overhead allocation may overstate the profit of the enterprise.
- The proposed amendment may result in unwanted consequences on those industries that takes long time to make their asset ready for use. The effect of this amendment is not only limited to the mining and extracting industries but will spread to every industries.
The Financial reporting council of United Kingdom is in disagreement with the amendment in IAS-16 Property, Plant and Equipment as the allocation of overhead to that item of revenue generated by selling items or scrap, is not measurable and will not provide faithful presentation of financial statement. The main reason behind such disagreement is listed below:
- The exposure draft itself clarify the industries on which the said amendment will be effective namely extraction and mining industries but the effect of the said amendment will also on those industries which takes time in testing and quality checking of such assets.
- In profit & loss account, in case of an item of revenue which is generated in the ordinary course of business and the cost associated with such item is properly allocated to that product with appropriate allocation of overheads to determine the overall profitability of that product. Whereas allocation of overhead or other costs to the item or scrap generated in the process of making property, plant and equipment ready for use is difficult to ascertain and this will lead to the overstating the overall profit of the company.
- The said amendment is not in line with the provisions of IFRS 15 ‘Revenue from contracts with customers’. It may be possible that the scrap dealer can be the customer of the company and if so, it is unjustifiable to aggregate revenue from different sources into one category whereas IFRS 15 requires users to disaggregate the items of revenue into category.
- The said amendment will only be applicable to those industries engaged particularly in the mining and extraction business. It would not be desirable as the cost, which is to be capitalized, can only be traced with such assets and there is a diversity in the reporting of such capitalized cost.
The Institute of Chartered Accountants of India is not in the agreement with the amendment regarding IAS 16 Property, Plant and Equipment. The main reasons behind such disagreement is listed below:
- The amendment is not in accordance with the basic principles of accounting. It is dealing in improper manner, which is not appropriate. Under IAS 23, “Borrowing costs” the borrowing costs should be capitalized net of interest income earned from such borrowing. Hence, the revenue generated should be deducted from the cost of the asset instead of charging it to profit & loss account as item of revenue. By the virtue of IAS 23, Institute of chartered accountants has tried to explain the recognition of borrowing costs in financial statement. In IAS 23, borrowing costs are categorized in both as a liability in an addition to the existing loan obligation and an interest expense as a charge against profit. The treatment depends upon the use of loan fund obtained. If the loan fund is used in the construction of an asset then such expense should be capitalized in the value of the assets and if such loan has been used for working capital requirement then the interest expense should be charged to profit & loss account net of any recoveries made. In similar way, where any cost directly attributable to such asset shall be added to the cost of such asset net of any recovery i.e. sale of scarp or input produced during testing phase.
- Para 16 of IAS 16 states that any cost that is directly traceable to the activity of making the asset available to use shall be capitalized in the value of asset and any asset incurred after the recognition of the asset shall be charged to the profit & loss account of the said company. Further, para 17 specifies the examples of directly traceable costs. The proposed amendment is not in line with previously mentioned Para.
- The testing and quality checking process is the process to check the reliability and effectiveness of the property, plant and equipment in the production process based on standards prescribed by the management. However, any item, which is produced during that testing process, is not the part of the company’s commercial activities or is not produced in the normal course of business. Therefore, treatment of the said input or scrap generated during testing process as similar to the commercial products manufactured during normal course of business is not justifiable. As the normal commercial activities of the business has such cost structure which consists of allocable overhead but the items that are produced in the testing process has not properly linked with the identifiable overheads related to such process. Allocation of overhead to the waste or items generated during such process of testing or quality checking of plant, property, equipment is quite difficult task, and it will take significant effort and time to determine the allocable overhead to such waste and inputs. The draft itself have not provided any guidance note and neither have explained method of measurement of the cost associated with such waste or input.
Conclusion:
From the analysis of comments and the contents of exposure draft, it can be concluded that the inclusion of revenue generated through sale of inputs or scrap generated during testing phase in the revenue statement of the company or doing same treatment of such revenue similar to the revenue generated in the ordinary course of business is not appropriate. The nature of both revenue sources is different from each other. Therefore, such recoveries shall be reduced from the cost of such property, plant and equipment.
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