Assignment Specifications
Purpose:
This assignment aims at developing a clear understanding of students on Accounting standards for lease. Students are required to critically examine the new accounting standard for lease financing AASB 16. They will have to do research on relevant literature and demonstrate understanding and critical evaluation of key issues and different provisions on accounting standards for lease financing. They will have to refer and base their discussions on a complete understanding of AASB 16 Accounting for Leases.
Required Task:
In the body of the assignment, students will have to critically discuss the following issues:
- Critical evaluation of the old accounting standard for lease (AASB 117) specifically highlighting the drawbacks
- Why was the change necessary?
- What changes have been incorporated in the new accounting standard for lease AASB 16?
- How will companies that have significant level of lease financing be affected by the change in the accounting standard for lease?
- In the former accounting standard for lease (AASB 117) both operating lease and finance lease were allowed, why did companies have a tendency to classify most of the lease contract as operating lease? How does positive accounting theory relate to this behaviour of managers?
- According to the IASB, the implementation of IFRS 16 (the IFRS version of AASB 16) is expected to improve comparability between companies that lease assets and companies that borrow to buy assets. Explain this view of the IASB with suitable example.
- The implementation of AASB 16 might have an effect on the leasing market if companies decide to buy more assets and as a result, lease fewer assets. Provide possible explanation as to why after the implementation of AASB 16, reporting entities might be more likely to buy more assets and lease fewer assets.
- Select the latest (2017 – 2018 financial year) annual report of an ASX listed company. Summarise the key disclosures the company has made on its accounting for leases including on the transitional provision and effect of the transition to AASB 16 from AASB 117.
Solution
Abstract
This report is based on critical evaluation of the changes and the requirements of AASB 16, a new Australian accounting standard for lease financing. This report is based on a different section and parts. Some of the key areas covered and discussed in the report included the evaluation of drawbacks in AASB 117 that was a standard for leases. The next couple of parts of the report evaluated that what was the reason due to which the changes were required and what are those key changes which have been made in the new AASB 16? The next part of the report evaluated the certain level fo impact of the new AASB 16 on companies. The importance of the implementation of IFRS 16 has also been discussed in the report based on its importance in increasing comparability. At the end of the report, key disclosures of a company have been evaluated based on annual report data.
Introduction
AASB 16 is introduced by the Australian accounting standard for increasing transparency of an organization’s reports based on leading to an increase in the company’s liabilities and leased assets of the lessee. A single accounting model for lease has been introduced by AASB 16 along with the requirements to recognize all leased liabilities and assets in financial statements. The key requirement regarding the lease transaction considered in the AASB 16 is right-of-use recognition of leased company’s assets and liabilities related to that particular leased asset. This new standard will be applied for that annual reporting period that had started after the 1 January 2019 (Martin, 2017).
Critical evaluation of AASB 117
According to the definition presented in AASB 117, finance leases are the leases which purchase of assets was based on similar financial circumstances based on which these leases were required to report in the balance sheet. The operating leases about AASB 117 were all leases other than finance leases, but they were based on different procedures of reporting. The key area of consideration in this standard for making the difference in between the operating and finance lease was that extent of rewards and risks related to leasing asset’s ownership lie with the lessee or the lessor. In case when transformation of rewards and risks occur substantially to the owner than in that case the lease was classified as the finance lease but in contrast to it in case of operating lease, the AASB 117 considered that operating lease would be that in which the risks and the rewards would not be transferred substantially to the ownership of the leased asset (AASB, 2004). Some of the drawbacks extracted from the AASB 117 included the standard required to recognize the payments that are made in respect of operating lease as am expanse by the following method of straight-line basis. It was one of the drawbacks in this standard that it required the adoption of this method unless presentation of alternative systematic basis in the context of the time pattern of the benefits of users. In the context of the finance lease, the drawbacks were based on the recording of the financial liability in the lessee’s balance sheet while the split of the lease payments between the interest and depreciation was stimulating in profit and loss account of an organization. In this way, the recording of the finance and operating lease based on substance form rather than form was one of the key areas of the gap in AASB 117. This way of recording might create a concern that some of those assets are comprised in the company’s financial position statement to which there is no legal title for the company (Joubert et al., 2017).
Why changes were needed
The changes in the AASB 117 were needed because of the reason that most of the companies were classifying the leases as operating leases which was a key concern that some of those assets of the company which is critical and important for the company is not recording in financial statements. The classification of leases as an operating lease under AASB 117 would also create a risk of understatement of the liabilities of the company. Treatment of operating lease by the AASB 117 was also created an opportunity for financial statements users such as banks and analysts to make adjustments in the context of commitment regarding the operating lease which have an impact on the decision-making the process. So there was a threat their adjustment is made incorrect and accurate way. The main reason based on which lease was considered by the management as an operating lease under the AASB 117 was that the threats and rewards of the ownership of asset leased could not be transferred substantially. Another important factor of the need for changes included that under the AASB 117, there was the only requirement for the lessees to off-balance sheet all those leased assets and their liabilities which are not finance leased assets. This could be the reason for the provision of misleading information in financial statements. The changes were important because AASB 117 could result in affecting the faithful representations of the transactions of leasing. Under the use of AASB 117, it might also the concern that actual financial position of an organization is not presenting because it was allowed in AASB 117 to not include future payments of the company in respect of operating lease (Wong & Joshi, 2015).
Changes incorporated in the lease AASB 16
The elimination of the treatment of classification for both the operating and finance lease was incorporated in this new standard. The provision of a single treatment model was a great change in AASB 16 to recognize both leases in the balance sheet. In this way, the new AASB 16 makes a valid change in the method by which leases should be accounted for in the balance sheet. New lease AASB 16 created obligations in respect of recognition of lessee’s liabilities and assets that have held by the owner for at least more than 1 year. The using right of asset is required to be recognized in AASB 16 to indicate the right of using the asset leased and associated liabilities regarding that particular leased asset. The requirements regarding the measurements of non-financial assets are also changed in the AASB 16. In this way, the new AASB 16 created a need for measuring all the using rights similarly to all other non-financial assets and the liabilities similarly to all other liabilities. It makes changes regarding the initial measurement of leased assets and liabilities because now it is required to measure these initially at the present value basis. Payments to be made in optional periods and non-cancellable payments are obligatory to be comprised in measurement in case lessee is considering retaining or extending the lease. A certain level of disclosure requirements also changed in AASB 16 because now it is a requirement for the lessee to include the judgment-based disclosure regarding the effect of leased asset and liability on the financial position (Treasury, 2017).
The impact of change in standard on the companies having a significant level of lease financing
There is a certain level of the impact of new changes and a new standard of AASB 16 on those companies which are operating on a significant level of lease financing. Debt covenants, EBITDA, and ratios (debt-to-equity) are some of the crucial metrics which would be affected by the method of recognition under AASB 16. The impact would be created because of the reasons that under AASB 16, the companies based on leased financing to consider all the terms of new leases and ongoing leases along with their implications on the future performance and financial reporting of an organization. The most important thing is that AASB 16 will impact these companies more than just finance function because it requires the input of the company from the property and operational functions of these companies. Companies may be required to develop a specific data-gathering process to have such important information as to implement this new AASB 16 standards. The companies based on AASB 16 will be required to manage the leases in a comparatively decentralized way. Another issue for the companies would be that there could not an electronic form of those leased assets which had been entered into many years ago which could create a problem of calculating one-off impact of those leased assets and liabilities (Ohm, 2019).
Why lease contract was classified by the companies as an operating lease and how positive accounting theory relates to this
The key objective of the creation of the new standard was to eliminate the off-balance financing of the companies. At the time of implementation of AASB 117, the option of both the finance and operating lease was available, but the companies were referring to the classification of most of their lease contract as an operating lease. The main reason behind this behavior of companies was that classification of the leased contract as an operating lease would enable eth companies to not show the leases as assets and liabilities in the balance sheet. The consideration of a lease contract as an operating lease enabled the management to hide the real value of the liabilities from the stakeholders. Under AASB 117, there was a limited level of the requirement of providing the disclosure in annual reports regarding the operating lease and their treatment by the management. Another reason of classifying most of the lease contract as the operating lease was that under the AASB 117, it is not included in the requirement of companies that whether the company has a service contract or operating lease contract that was an opportunity for the company to account for both the contracts in the similar way of treating as an expense. At the time of AASB 117, companies were able to account for similar transactions of the company in a different way which was the main reason of reduction of comparability of users of financial statements of the company. Positive accounting theory could play an important role relating to this behavior of managers because it could help the management to make good predictions regarding eth accounting transactions. It is considered an effective way of choosing the right accounting policy for treating and managing the leased assets and liabilities (Brumm & Liu, 2019).
The implementation of IFRS 16 would improve comparability between companies
It is true that the comparability between the companies of borrowings to buy assets and to account for leases could be increased by the IFRS 16 application. In the context of the implementation of IFRS 16, those companies which are working on borrowing to buy the assets would not be required to similar amounts in profit and loss and balance sheet as lease assets companies. In the context of this standard, when a right is obtained by a lease, then a company would be required to recognize it as an asset. In this way, the treatment of recognition of assets that are purchased is different from the assets that are obtained through a lease under IFRS 16. It is considered a good option by IASB because the borrowings for buying the asset and the leases although are similar in the economic term, but they are not the same transactions. IFRS 16 by treating borrow for asset buying businesses and assets on lease businesses in a different way have reflected financial flexibility. In this way, the comparability could be improved by the IFRS 16 between borrow for asset buying businesses and assets on lease businesses (Morales & Zamora, 2018).
Reasons behind buying more assets by reporting entities and lease fewer assets after AASB 16 implementation
AASB 16 application has brought a certain level of changes in the treatment of lease assets to reduce the controversy of off-balance sheet leases. The imperative area of changes is the new rules regarding the exemptions that were available for the companies regarding the low value and short-term leases. This becomes the reason for focusing on buying more assets and lease fewer assets by the companies. The management of companies has realized that after the implementation of AASB 16, the treatment of lease assets and other liabilities would be similar so it will upsurge valuation of liabilities in the balance sheet. The industry expert thinks that after the AASB 16, companies should have to prefer to buy the asset rather use the leased asset because lease option could bring changes ratios calculation which derived using information of annual reports. Another important factor is that implementation of AASB 16, would result into a condition that some companies would not comply with the debt covenants in case these debt covenants are associated with eth financial statements of the company without having required adjustments for off-balance sheet leases (Skinner, 2018).
Key disclosures the Alumina Limited regarding accounting for leases
The annual report of Alumina Limited for the year ended 2018 revealed the disclosure of company regarding AASB 16 that was expected to come in 2019. The company revealed that the company had not yet adopted it because it will be effective from first January 20019 and its requirements are not mandatory for the company for the year ended 31decemnber 2018. This is the reason that the company did not adopt this standard of AASB 16 before its mandatory date. The company had disclosed in eh financial statements that AASB 16 would be applied in replacement of AASB 117 based on which the leased asset and liabilities have been accounted for by the company till the end of the year 2018. It is clearly described in the disclosure that after the implementation of AASB 16 leases, the company will be liable to apply the new requirements to both the pre-existing and new lease arrangements. The key changes required to be made by the company will include:
- It will be mandatory for The Alumina Limited to recognize an asset using rights in respect of all the lease contracts and to recognize the lease liability, which would also reflect the future payments of Alumina Limited.
- The straight line method will be required to use to present depreciation on that asset for which there is a right of using it and expense of interest in respect of lease liability of leases in the income statement of Alumina Limited.
- The third change will be based on the presentation of those payments of the lease that reflect interest as an operating cash flow. It will be required for the Alumina Limited that its financial activities portion of the cash flow statement should classify the cash payments of Alumina Limited. While operating activities will include the payments for low valued asset and short term leases of Alumina Limited.
The implementation of AASB 16 leases will be mandatory for the first interim periods within the annual financial period of Alumina Limited starting on or after first January 2019.
The accounting for the operating lease commitments of $0.3 million, which will be non-cancelable, would be the first primary affected area after implementation of AASB 16. This is the reason that there will be no material impact on the income statement and balance sheet of Alumina Limited (Alumina limited, 2018).
Conclusion
It is concluded that the changes were needed to be made in the AASB 117 Leases. The reason concluded is that most of the companies started to account for the leased asset as an operating lease which was not required to be included in the balance sheet. AASB 16 leases have created more transparency and accuracy in the financial information for the users. An important aspect regarding the AASB 16 is concluded that after its implementation, the companies started to purchase the assets relatively than leasing assets.
References
AASB, 2004. Accounting Standard Aasb 117. [Online] Available at: https://www.aasb.gov.au/admin/file/content105/c9/AASB117_07-04.pdf [Accessed 29 May 2019].
Alumina limited, 2018. [Online] Available at: https://www.aluminalimited.com/uploads/Alumina-Ltd-Annual-Report-2018_ASX.pdf [Accessed 28 May 2019].
Brumm, L. & Liu, J., 2019. New leasing accounting standard. Taxation in Australia, 53(8), pp.449-60.
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), pp.1-11.
Martin, R., 2017. A new approach to lease accounting. [Online] Available at: https://www.rsm.global/australia/insights/ifrs-news/new-approach-lease-accounting [Accessed 28 May 2019].
Morales, J.D. & Zamora, C.R., 2018. The impact of IFRS 16 on key financial ratios: a new methodological approach. Accounting in Europe, 15(1), pp.105-33.
Ohm, M., 2019. New leasing standard (AASB 16) brings significant impacts. [Online] Available at: https://www.hlb.com.au/new-leasing-standard-aasb-16-brings-significant-impacts/ [Accessed 28 May 2019].
Skinner, S., 2018. A Simple Guide to: AASB 16 – Leases. [Online] Available at: https://www.linkedin.com/pulse/simple-guide-aasb-16-leases-steven-skinner-fcpa-gaicd-fei [Accessed 28 May 2019].
Treasury, 2017. Guidance for AASB 16 Leases. [Online] Available at: https://www.treasury.nsw.gov.au/sites/default/files/2017-04/Guidance%20for%20AASB%2016%20Leases%20-%20New%20Lease%20Standards.pdf [Accessed 28 May 2019].
Wong, K. & Joshi, M., 2015. The impact of lease capitalisation on financial statements and key ratios: Evidence from Australia. Australasian Accounting, Business and Finance Journal, 9(3), pp.27-44.
