Its Impact on the Financial Position and Performance of Australian Companies
Abstract
Lease Accounting is an area which currently has different practices proposed in IFRS and US GAAP. Even lease accounting practices are not interpreted in the same way by different companies within IFRS. This causes confusion for the investors as due to different interpretation by different companies leases are accounted for differently in the annual report and accounting books. This causes problem for regulators, government and investors to judge and rate companies uniformly. As an effort to consolidate and bridge the current gaps, IFRS and US GAAP have come up with Exposure Draft –ED 202. There are some sweeping changes proposed in the lease accounting practices. Australia is a country where most of the companies still follow the IFRS lease accounting practices but sudden changes in the same will affect these companies very much. This new lease accounting practice not only will change the way companies are mandated to bring in all leasing information in the balance sheet and cash flow statement but companies will also require to publish lease liabilities in the current financial statement after discounting.
Introduction
IFRS and US GAAP came up with a joint exposure draft in August, 2010 for lease agreement accounting practices. This draft proposes sweeping changes in the way currently the lease agreements are accounted for in the balance sheet and suggests changes very different from the previous changes. This paper will discuss upon the current lease accounting practices of Australian companies and how the changes proposed in lease accounting is going to affect them.
Current Lease Accounting Practices of Australian Companies
Australia is one of the major mining hubs of the world. Mining and oil extraction and exploration companies use leasing agreement most among all types of companies. Any change in lease agreements will affect these companies in a big way. Let’s now look at the current lease accounting practices of Australian companies.
Land is mainly carried into the book of accounts at cost as it is not possible to estimate the market value of land. It is even difficult to value the actual cost of the land with buildings and equipment in it (Davies, Mortensen and Patton, 2007). Depreciation of the leased property or equipment is done to their residual value over the period of its estimated life and is reassessed annually. In case of equipment, if the estimated life is more than the life of a mine then the value of the equipment is amortized over the lifespan of the mine using a straight-line method (Edman, 2011). Operating lease assets are not capitalized and only rental payments are included in the income statement. Provision for the assets are made only when it is determined that the asset will no longer be profitable. Operating lease incentives are recognized as liability in balance sheet and subsequently reduced by allocating lease rental payments and reduction in liability. Future obligations arising out of lease agreements are not shown in the balance sheet and shown as commitment for the company in future (PWC, 2010).
Proposed Changes by Exposure Draft
The main objective of FASB and IASB is to make the lease accounting more transparent for the stakeholders and investors by bringing in more information about the lease obligations. The main changes proposed in the exposure draft are discussed below.
The first and foremost thing proposed by the exposure draft is to classify its assets in either category A asset or category B asset. The recognition of the asset type is done with the help of right-of-use of the asset. For type ‘A’ assets the asset needs to be reflected in the balance sheet in the same way as any company will do for its own assets. Generally plant, equipment and building are classified as category ‘A’ asset (Exposure Draft Leases, 2010). They need to be amortized in a straight line method. For type ‘B’ assets, lessee’s needs to amortize the right-of-use assets each period is based on an interest rate method discussed in detail later in the essay (Baker-Tilly, 2013).
Off balance sheet treatment of the leases are no longer entertained in this draft. All lease agreements should be recorded in the balance sheet. Lessees need to account for accelerated income and expense accounting for type ‘A’ leases and normal straight line amortization technique for type ‘B’ leases (Gilliam Coble and Moser, 2013). The accounting model applied by the lessees and the lessors for a particular lease to derive its liability will depend on the underlying ability of economic benefit from the lease agreement lessee is expecting. In simpler terms, the liability is calculated as the present value of the lease liability less any incentive received from the lessor. Lease liability then needs to be amortized based on the effective interest rate method. As per this method lease payments needs to be apportioned between interest expense and reduction in the remaining lease liability.
The determination of the lease term would include periods in which the lessee can come up with significant economic incentive to extend or not terminate the lease. This will also include the periods covered under renewal option (Stafford, 2010). In certain situations, variable lease payments need to be frontloaded in the balance sheet for lessee and lessor’s initial accounting of the lease.
As per current standards, financial leases are part of the balance sheet but operational leases are not part of the balance sheet. This exposure draft tried to also bring in the details of operating lease in balance sheet and in cash flow statement (Bennet and Webb, 2010). However, while trying to do that, FASB and ISAB have made some suggestion which have made matters more complicated. Even if the companies start using this lease accounting practice, it will not be easy for the stakeholders and investors to interpret the numbers from the balance sheet. If implemented, a lot of companies may be encouraged to shift towards the short term lease agreements of less than twelve months or in some cases companies will try to create an agreement in such a way that it will be a service agreement between two parties and not a lease agreement (Chang and Adams, 2012). Additional disclosures clauses like residual value and interest rates will definitely provide more transparency to the investors, stakeholders and financial authorities.
Implementing this new accounting practice will definitely demand extra cost for the company as it requires more extra accounting details to be in place. The cost will not be very high but it will definitely put smaller players at a disadvantage compared to the bigger players in the market (Deloitte, 2011).
How the New Draft Will Affect Australian Companies
As per the new draft, if the lease agreement is of more than a year for the asset type ‘A ‘and the value of lease payment is more than insignificant relative to the fair value then the asset should be treated similar to an owned asset ( Drummond, 2012). Suppose a company got oil rig equipment set in Perth as per a lease agreement from a lessor for 12 years. The oil rig set lease payment is $20,000/month. Present value of that is equal to $55,000 calculated based on the interest rate charged by the lessor to the company. Fair value of the equipment is $200,000. The company needs to put the present value of the equipment as the liability for the company in the balance sheet and should reduce it as and when it makes the payments using interest rate method. If the companies suddenly start to use this technique for its balance sheet and reporting, the liabilities will go up very high and that may reflect a highly leveraged image of the companies.
The exposure draft proposes that operating leases now should be accounted for as type ‘A’ or type ‘B’ leases and then should be accounted for in the financial statement as per the new exposure draft. Suppose a company has a five year contract starting from 2012 for an oil tanker ship. As per the current accounting practice, it already has paid the lease for the first year in the amount of $330,000. The amount is reflected in the income statement for the year 2012. If the company decides to move on to the new accounting practice as mandated in the 2010 exposure draft then first it needs to determine if the lease asset type is ‘A’ or ‘B’. In this case the ship is of asset type ‘A’. After it is determined the accounting will change in some way. First the equal rent payments for next four years need to be converted to present value using a discount rate. In this case it is $1,124,620 using a 6% discount rate. This needs to be accounted for in the balance sheet in the following way:
Finally, exposure draft proposes a different method of accounting for Type ‘B’ assets. As per the current practice, land is not depreciated as it is very difficult to come up with a fair value or market value with all the other assets present on it. In this case the fair value of the asset is calculated based on the present value of the future lease payments and then it is accounted for in the balance sheet in the same way as Type ‘A’ asset (Studley, 2013).
Conclusion
The new exposure draft 2010 has changed the way leasing accounting should be done. If implemented, this will force the companies in Australia to change its leasing accounting practices drastically. Sudden implementation of these changed accounting practices may mislead its stakeholders for the next few years as the liabilities in the balance sheet for the company will skyrocket due to the acceleration clause of the exposure draft. It will also require the companies to change its current practice of balance sheet accounting to account for the lease related changes. Furthermore, companies need resources to maintain more detailed leasing information and then translate that information into financial statements and reports. However, the exposure draft is seeing lot of resistance from different corners and may go through several amendments before it is implemented as the industry standard accounting practice.
Work Cited
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Bennet, Doug and Webb, Travis. 2010. Lease Accounting Exposure Drafts – What You Need to Know. BKD. Viewed on 15th October 2013 < http://www.bkd.com/articles/2010/lease-accounting-exposure-draft-what-you-need-to-know.htm>
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