Purpose of the assessment (with ULO Mapping)
Students are required to critically examine the Australian 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 such as the drawbacks of the previous lease standard, why was the change necessary, what changes have been incorporated in the new accounting standard for lease AASB 16. They will also need to conduct minor empirical research (on a specified company) on 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 paper is focused on analysis related to the transition of AASB 117 to AASB 16. Both these standards are associated with disclosure of lease-related projects in the financial statements of the public limited companies. AASB 117 was previously implemented across all Australian public limited companies, and recently it has been replaced by AASB 16. A significant reason behind the replacement of this standard was to standardize the disclosure of lease-related projects in the financial statements. This would enhance the level of comparability and will help to provide detailed information to shareholders and stakeholders related to leasing transactions in the financial statements of the company. The study suggested that most of the companies during the old standard were not transparently disclosing complete information related to leasing projects. Orica Company was selected to analyze their financial statements, and their financial statement has properly disclosed the leasing project in the balance sheet and details have been properly disclosed in notes to the account.
Introduction
This assignment is related to the analysis of Australian accounting standard board 16 and Australian accounting standard board 117. Recently, Australian accounting standard board 16 has been launched to provide guidelines regarding the disclosure of lease contracts in the financial reports of the public companies while previous Australian accounting standard board 117 was being utilized for this purpose. One of the most significant differences between the old and new standard is that the old standard had flexibility regarding categorization of lease contracts. Lease contracts can either be categorized as capital lease contracts or operational lease contracts.
Due to this flexibility, it was difficult for the shareholders and users of financial statements to compare the lease related disclosure in financial statements of a public limited company. According to the new standard, it was made mandatory that every organization should categories their lease contracts as capital contracts to avoid any kind of confusion and to enhance the level of compatibility between the financial statements of different public limited companies in Australia and around the globe.
United States Securities and Exchange Commission and other stakeholders were concerned regarding the usage of the old standard of the lease. Different shareholders and investors were also concerned regarding the old standard. Even International financial reporting standard board was not happy with the guidelines provided by the old version of the leasing standard, and it was an important requirement to update the standard to resolve the concerns of IFRSB and SEC (Meislik & Horn, 2010).
Critical evaluation of the old accounting standard for lease:
There were different drawbacks related to the old standard of leasing contracts. There were a significant number of issues and concerns raised by the United States Securities and Exchange Commission as well as different associated stakeholders and users of international accounting standard boards related to the leasing projects and usage of leasing standards in those projects.
The old standard was significantly criticized by stakeholders for not providing an appropriate and faithful representation of the leasing amount in financial statements of the company, which was significantly influencing the decision-making process of the shareholders and stakeholders. Due to disclosure issues, shareholders and stakeholders were not able to identify the proper actual financial position of the company related to leasing transactions. It was also identified by the Securities and Exchange Commission of the United States in 2005 that most of the companies are not disclosing their leasing related amount transparently in the financial statements. This was a major concern not only for the Securities and Exchange Commission but also for the shareholders and stakeholders of such companies. Off-balance sheet commitments related to leasing contract in the old standard was not disclosing the appropriate required information in financial statements. In 2014, approximately 3 trillion US dollars amount of leasing was disclosed by the listed companies in the United States due to a change in standard, and this was a significant amount. These drawbacks suggest that there was appropriate need of replacing the old standard of leasing with a new standard to provide a truthful representation of leasing contract in financial statements for the shareholders and stakeholders to the support decision-making process (Walker, 2011).
Why was the change necessary?
There were different reasons responsible for formulating and implementing the new lease standard by replacing it in place of old lease related standard. One of the most significant and main reasons behind formulating and implementing the new standard was to eliminate financing related to the off-balance sheet. The international accounting standards board was willing to formulate a lease related standard which could be utilized to classify the lease as or financing lease.
There were different issues and problems which were associated with the classification of the lease, either financing lease or operating lease under old standards. According to the old standard, if the lease is categorized as an operating lease, then it will not be categorized as an asset or liability in the balance sheet. This type of lease includes the expense in the income statement of the company due to which it is not mentioned in the balance sheet of the company (Silvia, 2019).
Due to this fact, proper liability related information was not disclosed in front of the users of financial statements and financial reports. This significantly influenced the decision making of the authority of shareholders and stakeholders of public limited companies. That is why the International financial reporting standards board was required to formulate amended standards related to leasing to solve issues related to the discrepancy of classification of the lease. After the formulation of new standard AASB 16, it is mandatory for the companies from an accounting perspective to make sure that they disclose every type of lease in their balance sheet. This will significantly help the shareholders and stakeholders in their decision-making process as complete information will be disclosed in front of them.
What changes have been incorporated in the new accounting standard:
AASB 117 classifies different leases as an operating lease or finance lease. As far as AASB 16 is concerned, it classified every type of lease as a financial lease. This is one of the main differences between the old standard of lease AASB 117 and new standard of lease AASB 16. however, In the new lease standard AASB 16, there is exception related to lease of fewer than 12 months which is also known as short term lease and lease related to low-value assets has also been exempted according to AASB 16.
There is no significant difference between lesser related regulations disclosed in old and new lease related standards. The same model which was adopted in the old standard has been carried forward to the new standard, but only the process related to disclosure has been enhanced to a new standard as compared to the old standard. By enhancing the disclosure process in the new standard, the Australian accounting standard board has enhanced the importance of lease-related standard in the formulation of financial statements and financial reports of the company.
Treatment-related to the calculation of residual value is considered to be one of the most significant differences between the old standard and new standard formulated by the Australian accounting standard board. According to the old standard, leveraged model related to lease was allowed while it is not allowed according to the new standard of lease AASB 16. According to the new standard, lesser is required to disclose an enhanced amount of information related to risk as compared to old and previous lease related standard (Silvia, 2019).
How will companies that have a significant level of lease financing be affected by the change in the accounting standard for lease?
Due to changes in the standard related to the leasing contract, companies are now required to categories the leasing contract as capital leasing instead of operational leasing. This will significantly influence the companies which were already categorizing the leasing contracts as operational contracts. These organizations will be required to transfer the number of their leasing contracts from the income statement to balance sheet. This will significantly reduce the expenses and increase the net profit of such companies. Their taxable amount and tax payable to the government it will also significantly increase. This suggests that their tax-related expenses will increase after transferring the leasing contract amount from the income statement to the balance sheet (Meislik & Horn, 2010).
Another significant influence will be the requirement to disclose complete information regarding leasing contract in the balance sheet and notes to the account. According to the new standard related to the leasing contract, it is mandatory for the organizations to provide detailed disclosure and information regarding the leasing amount in notes to the account to link it with the balance sheet of the company. This will significantly increase the short term as well as long term liabilities of the company, which will negatively influence the solvency ratios and current ratios of the company. It will also influence the working capital of the company. With a significant increase in short term liabilities, solvency ratios will negatively influence the decision-making process of most of the shareholders and stakeholders associated with the company. This will completely change the reputation of the company from an investment perspective in the stock market (Rice University , 2019).
Why did companies tend to classify most of the lease contract as an operating lease? How does positive accounting theory relate to this behavior of managers?
According to the old standards of accounting related to leasing contracts, it was optional that leasing contracts can be categorized as operational contracts or capital contracts. Most of the managers used operational contract category to categories leasing in their respective companies (Hayes, 2019). There are different significant reasons behind this decision made by most of the managers. One of the most significant reasons is that it allows reducing the taxable income significantly and reduces the tax expenses of the company. It can be suggested that the operational lease provides text bracket to the company by reducing the amount of tax payable by the company to the government.
Another significant reason behind is that if managers select operational categorization of the lease, then they are not required to show those lease amounts in the balance sheet as a liability. Due to a significant reduction in the level of liability in the balance sheet of the company, most of the investors are positively influenced, and shareholders are positively influenced thinking that the company does not have a high level of liabilities which is favorable from solvency point of view for going concern of the company (Tardi, 2019).
As far as accounting positive theory is concerned, it is closely related to the categorization of lease amount as an operational lease instead of a finance lease. This is mostly because the positive theory is associated with working in a value-free manner and same is the case with the operational lease as the management is not required to disclose the amount of lease contract in the balance sheet of the company (CFI Education Inc, 2019).
Comparability between companies that lease assets and companies that borrows to buy assets.
According to the International accounting standards board, implementation of new standard related to leasing contracts will decrease the cost as well as complexity for most of the companies. It will also significantly help companies to compare their balance sheets from a leasing perspective. It will reduce complexities and issues related to the comparability of leasing contracts. For instance, if any company has taken any asset on a lease, then it will be categorized under the liability section of the balance sheet, and the investors, as well as stakeholders, will be able to compare its value with the other companies in the relevant industry. As far as the company which has provided that specific acid on leaves will be able to record the leasing amount in its balance sheet as an asset and will be able to compare it with other competitors and relevant industry (IFRS, 2016).
This will significantly provide an opportunity for shareholders as well as stakeholders to compare the historical performance of leaving projects with the company. It will help the investors to make better decisions regarding their investment in that specific company. Before the implementation of this new standard, some of the companies were categorizing the leasing contracts as capital contracts while some of the companies were categorizing the leasing contract as an operational contract. Due to this difference, it was not possible for investors and users of financial statements to analyze and compare the leasing contracts information available financial statements of different companies (Hayes, 2019).
The implementation of AASB 16 might affect the leasing market if companies decide to buy more assets and as a result, lease fewer assets:
There can be different significant responsible reasons for the increase in the purchase of assets as compared to the leasing of assets by the companies due to the implementation of the new standard. Some of the significant reasons have been disclosed in the section (Morais, 2014). One of the most significant reasons is that by purchasing assets, the value of the total Assets of the company will increase. If short-term assets are purchased, then current assets value will increase, which will positively influence the solvency ratios and solvency position of the company. If the management adopts the option of leasing assets instead of purchasing assets, then it will increase the value of leasing under liability category in the balance sheet which will ultimately reduce the value for solvency ratios and will increase the solvency risk associated with business operations.
Increase in the level of current assets specifically might be responsible for positively influencing the decision making of the investors and stakeholders in the market (Rice University , 2019). By the increase in the level of assets as compared to leasing, the profitability of the company will also be positively influenced as assets will be considered as expenditure and there will be disclosed in the balance sheet instead of the income statement. Due to change in such disclosure, the profit of the companies will start increasing, and it will positively influence the decision-making process of the investors and stakeholders in the market. That is why most of the companies will look towards purchasing assets instead of leasing assets by looking towards the potential benefits of purchasing assets in the long term.
Orica Company:
To analyze the disclosure related to the lease contract, Orica Company has been selected. Orica is a material related company and is operating under the industry of construction and material (Orica.Com, 2019). To analyze the disclosure related to lease contracts, the annual report of the company for 2018 has been analyzed. Analysis of annual report suggests that lease payments related to operating leases have been disclosed in the income statement for 2018 as well as 2017 in the consolidated form (Orica Limited, 2019).
Capital contracts related to lease has been disclosed in the balance sheet of the company. Company has both currents as well as noncurrent categories of lease liabilities. Current lease liabilities have tenure of fewer than 12 months while noncurrent lease liabilities have tenure of more than 12 months. Due to proper disclosure of lease contract and the financial statements of the company, it is easy for the shareholders and users of financial statements to analyze the transactions related to leasing contracts for the company. As far as details of lease contracts are concerned, proper details have been provided in the notes to the account to support the values disclosed in the balance sheet of the company. This detailed disclosure of the lease contract is mostly because of the requirements according to the newly formulated lease standard AASB 16. This will certainly increase the confidence of shareholders and interested investors in true and fair representation of financial data in the financial reports of the company (Orica, 2018).
Conclusion
In the end, it can be concluded that the implementation of AASB 16 has enhanced the reporting of related lease transactions as compared to AASB 117. With the implementation of the new standard, transparency related to disclosure of related lease transactions has significantly increased, which is a positive sign for the decision is making the process of the shareholders and stakeholders.
Disclosure of lease-related projects in the income statement of the company significantly reduces the profit margin of the company and does not provide investors with appropriate financial information or financial position regarding the lease transactions. Disclosure of lease-related projects in balance sheet helps to categories them under liabilities portion, which helps the shareholders and stakeholders to identify the actual position of the company related to leasing projects.
Orica Company has properly disclosed the details and information related to leases projects in the financial statements to enhance the transparency and to follow the formulated guidelines by the Australian accounting standard board. The new standard has also enhanced the level of comparability between financial statements of different public companies related to disclosure of lease projects.
References
CFI Education Inc, 2019. What is a lease? [Online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/accounting/lease-accounting/ [Accessed 29 May 2019].
Hayes, A., 2019. Capital Lease. [Online] Available at: https://www.investopedia.com/terms/c/capitallease.asp [Accessed 29 May 2019].
IFRS, 2016. IFRS 16 Leases Effects Analysis International Financial Reporting Standard. IFRS.
Meislik, I. & Horn, D., 2010. The Commercial Lease Formbook: Expert Tools for Drafting and Negotiation. 2nd ed. American Bar Association.
Morais, A.I., 2014. Why companies choose to lease instead of buy? Insights from academic literature. Academia Revista Latinoamericana De Administración.
Orica Limited, 2019. Company Reports. [Online] Available at: https://www.orica.com/Investors/company-reports#.XO2oNCAzbIU [Accessed 29 May 2019].
Orica.Com, 2019. Homepage. [Online] Available at: https://www.orica.com/ [Accessed 29 May 2019].
Orica, 2018. Annual Report 2018. [Online] Available at: https://www.orica.com/ArticleDocuments/1762/AR18_Orica_Annual_Report_WEB.pdf.aspx [Accessed 29 May 2019].
Rice University , 2019. Ethical Decision-Making and Prioritizing Stakeholders. [Online] Available at: https://opentextbc.ca/businessethicsopenstax/chapter/ethical-decision-making-and-prioritizing-stakeholders/ [Accessed 29 May 2019].
Silvia, 2019. IFRS16 Leases vs. IAS 17 Leases: How the lease accounting changed. [Online] Available at: https://www.ifrsbox.com/ifrs-16-ias-17-leases/ [Accessed 29 May 2019].
Tardi, C., 2019. Operating Lease. [Online] Available at: https://www.investopedia.com/terms/o/operatinglease.asp [Accessed 29 May 2019].
Walker, T., 2011. Managing Lease Portfolios: How to Increase Return and Control Risk. 2nd ed. John Wiley & Sons.
