New Accounting Standards have been developed and issued by Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). Before issuance of these new standards AASB 16, there were different views on understanding its treatment to the users of financial statements. Spencer and Webb (2015) had reviewed this standard and stated about the impact of this new standard on treatment of leases and on its users.
Lease transaction said to be started around 2010 BC (Nevitt and Fabozzi 1985) and has no standard on leases that time. In 1964, The Accounting Principles Board opinion No. 5 had issued ‘Reporting of Leases in Financial statement of leases that describes about treatment of capital leases by lessee. Then further lot more regulation and standards were issued on leases and current is International Accounting standard (IAS) 17 (IASC 1997).Operating lease are not recorded in balance sheet and future minimum lease payment are disclosed in notes to financial accounts of lessee. Now on the recommendation of G4+1, FASB and IASB have proposed new accounting treatment for operating leases, in 2010 and 2013. In Proposed new accounting standard, except the lease having maximum possible term more than 12 months, both lease (Capital and operating) are recognised as asset and liability in financial statement.
Current most debate point is recording and disclosure of lease in income statement. The debate is how to record lease- as rent expense, Depreciation (Amortization) or interest expense. This analysis will help to understand the problem and its proposed solution.
Analysis of academic literature of lease by Spencer and Webb (2015)
Over the past several years accounting treatment of leases is debatable. Spencer and Webb (2015) studied about why organisation involves in lease transaction, methods of evaluation of operating lease in financial statement and how users can will be able to understand actual information about lease treatment. Currently, Capital Leases is taken as purchase item which was shown in balance sheet whereas Operating leases was an off-Balance sheet item and disclosed in the footnotes of Balance sheet. For operating leases only single item rent expenses is recorded in income statement and future minimum lease payments are disclosed in footnote of financial statement. If the lessee uses almost all the useful life of asset, then Interest and amortization approach (I&A) applies under which Capital leases is recorded as asset and liability in the balance sheet and interest is accrued on liability part and asset is amortised ( charged as a depreciation) over the life of term of lease. Other than above case, there applies SLE approach where whole lease payment is charged in income statement.
The main objective of reporting financial statement is to provide information to users for taking economic decisions. So organization reports their asset and liabilities in financial statement. In the case of non-cancellable lease agreement, lessee will get future benefit and also have to make future sacrifice, thus have the characteristics of both asset and liabilities. Hence it can be said that operating lease too is very important one to have proper recording and treatment in financial statement.
Capital and operating leases are economically similar transactions but have very different accounting treatment which may result people may manipulate the transaction to show in financial statement as per their beneficial. Due to different accounting treatment of Capital lease and operating lease, it is difficult for the investors/ users of financial statements to understand the organization’s actual indebtness. Professional are only able to make real estimates, however average knowledge investor cannot get actual pictures. Large amount of criticism explains organisation does mainly operating leases to get off Book reporting. Thus this theory draws a lot of criticism.
ASSB 16 and Disclosure of Operating Lease
The major changes of AASB 16 is bringing the mandate of reporting operating lease in Balance sheet. This changes not only brings process and control of lease but also change in debt covenants, credit rating and tax effect accounting and improves financial metrics like gearing ratios, asset turnover and EBITDA. Previously operating lease is shown as off balance sheet, but now it will be recognise as right of use (asset) and liability. As a result lessee will charge depreciation on asset part and interest in liability part segregating lease liability into interest and principal portion. AASB 16 also requires proper disclosure for lessees and provides proper information to users of financial statement to understand effect of lease on financial position, financial performance and cash flow of lessee. For lessor, AASB 16 also requires more disclosure of lease which will provide quality information about a risk exposure of lessor.
Disclosure by lessee
Lessee recognise operating lessee in financial statement as asset and liability. This asset and liability recorded in balance sheet are measured in present value of future minimum payment. And in income statement these operating lease are recorded depreciation for asset and interest for liability part.
A lessee shall disclose right to use asset in financial statement and present separately from other asset and if it is not shown separately then it is shown with the similar line of asset which are owned. For lease liabilities, it is also separately presented from other liabilities. And if it is not separately shown then it should be disclosed in notes where they are shown in financial liability.
Disclosure of lessor
Lessor classifies lease into financial lease and operating lease. Lessor recognise financial lease in the financial statement with the amount equal to net investment of lease by using interest rate of implicit. Manufacturer and dealer recognises financial lease with the revenue amount either being fair value of asset or present value of lease payment whichever is lower. If there is any modification in the asset, lessor must evaluate the asset as new lease from the date of modification must considering the future accrual and prepaid lease payment. A lessor treat operating lease payment as income in his book. Lessor record these operating lease on some systematic basis- may be in straight basis or another appropriate base. The expense occurred on earning the income by leasing the asset (including depreciation) are recognised as cost and shown in income statement on the same basis as the lease income is booked. Lessor should use depreciation policy for lease asset as he uses normal depreciation policy for other depreciable asset. Lessor should follow AASB 116 and AASB 138 for calculating the amount of depreciation. Not only recording in financial statement AASB 16 also focuses on disclosing properly for useful information to users.
Thus, primary objective of disclosure of lease by lessee and Lessor is to disclose the operating lease in financial statement appropriately to provide qualitative and quantitative information which fulfil the objective of providing information to users about the effect of lease on the financial position, financial performance and cash flow of the organisation.
In case of non-cancellable lease agreement, lessee will get future benefit and also have to make future sacrifice, thus have the characteristics of both asset and liabilities. Organization should reports their asset and liabilities in financial statement truly and faithfully because it is the base on which users take their economic decisions. But currently operating leases is shown as off balance sheet item and thus this treatment does not show faithful economic characteristics.
Leases in income statement are reported either as rent expense, depreciation expense or interest expense. Rent and depreciation is operating expense and reported under operating income whereas interest is not operating expense, it is finance expense and reported under non-operating income. . Reporting adequately and transparently enhances useful of financial statement for users so disaggregation of information is very essential. Hence qualitative and quantitative disclosure of leases in financial statement increases more useful, reliability of the financial statement.
Over the past several years FASB and IASB has issued various notifications for the accounting treatment of operating leases. FASB proposes organisation should continue to show only single expense in income statement whereas IASB proposes organisation should show interest and depreciation expense separately. Thus IASB proposed (AASB 16) standard will provide much greater accuracy and transparency in accounting treatment of leases
Accounting Principles Board (APB). 1964. Reporting of Leases in Financial Statements of Lessee. Opinion No. 5. New York, NY: AICPA.
BDO Australia. 2016. New leases standard requires virtually all leases to be capitalised on the balance sheet. [Online] Available from https://www.bdo.com.au/en-au/accounting-news/accounting-news-february-2016/new-leases-standard Accessed July 20, 2017.
Boundless. "Overview of Lease Accounting." Boundless Accounting Boundless, (2016). Available from https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/special-topics-in-accounting-income-taxes-pensions-leases-errors-and-disclosures-15/lease-accounting-93/overview-of-lease-accounting-405-4237/ Accessed 20 July, 2017
Deloitte. 2011. How Prepared Is Your Organization to Cope with These New Standards? A Deloitte Survey on the FASB’s Proposed Changes to Lease Accounting Standards.[online] Available from: https://www.iasplus.com/en/binary/usa/1102usleasessurvey.pdf Accessed July 19, 2017
Equipment Lease and Finance Association (ELFA). 2013. Equipment Leasing and Finance Association Statement on FASB/IASB Exposure Draft on Lease Accounting.[Online] Available from: https://www.elfaonline.org/News/Press/pressreleases_report.cfm?ID¼20913 Accessed July 19, 2017
Financial Accounting Standards Board (FASB). 2010a. Conceptual Framework for Financial Reporting: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. Statement of Financial Accounting Concept No. 8. Norwalk, CT: FASB.
Financial Accounting Standards Board. 2016. Why did The FASB issue a new standard on leases? [Online] Available from https://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1351027207574 Accessed 20 July, 2017
International Accounting Standards Committee (IASC). 1997. Leases. International Accounting Standard 17. London, U.K.: IASC.
Kpmg. 2017. Leases –Transition to AASB 16. [Online] Available from https://home.kpmg.com/au/en/home/insights/2017/03/leases-transition-to-aasb-16-webinar.html . Accessed July 18,2017
Koo, J., (2016). Australia: Big changes to accounting for leases from 2019. KordaMentha. [Online] Available from https://www.mondaq.com/australia/x/509446/Forensic+Accounting/Big+changes+to+accounting+for+leases+from+2019. Accessed July 19, 2017
Lease Accelator.2017. A Brief History of Lease Accounting.[Online] Available from
https://explore.leaseaccelerator.com/history-lease-accounting/ . Accessed July 18, 2017.
Nevitt, P. K., and F. J. Fabozzi. 1985. Equipment Leasing. 2nd edition. Homewood, IL: Dow Jones-Irwin.
PWC. 2016. Key Developments in lease accounting.[Online] Available from https://www.pwc.com/us/en/cfodirect/issues/lease-accounting.html Accessed 20 July, 2017
Spencer, A. W., and Webb, T. Z., (2015). Leases: A Review of Contemporary Academic
Literature Relating to Lessees, American Accounting Association, Vol. 29, No. 4, pp.997-1023
Spencer,A.w., and Turek, M., Webb, T. Z., (2013). Changing standards for leases: What lessees need to know. Corporate Finance Insider.[online] Available from https://www.aicpastore.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2013/CorpFin/changing-standards-for-leases.jsp. Accessed July 18, 2017.