Key features and classification of IAS 17 leases

IAS 17 Leases

Explain the key features of the current accounting standard. You should use at least one illustrative example for lessee accounting from a published set of financial statements to illustrate the effect of the standard

IAS 17 accounting standard establishes and elucidates the pertinent accounting procedures and also disclosures that are supposed to be employed in accounting by lessors and also lessees. The lessor is the owner of the underlying asset while the lessee is the party that opts to make use of the asset at that point in time. One of the key features of the accounting standard is the classification between an operating lease and a finance lease. A financial lease is a contract or agreement whereby all of the risks and the rewards that are characteristic to the ownership of the asset are transferred to the lessee. On the other hand, an operating lease is a lease that is not classified as a finance lease. Classification is a very important aspect and key feature of the accounting standard. The risks that are associated with the lease include the taking care of the costs of the maintenance of the asset or also incurring the loss in terms of the depreciating value of the asset due to it become technologically out of date. The rewards on the other hand which are associated with the asset encompass making use of the asset for significantly the whole useful life of the asset and also making the most out of the profits that emanate from using the asset. In addition, with regards to the finance lease, the ownership of the asset passes on to the lessee when the leasing period comes to an end. The lessee also has the chance to buy the asset at a cost that is considerably lower compared to the value of the asset. A finance lease is categorized when there is minimal or no risk at all to the lessor. The leasing period is almost as the useful life of the underlying asset. Any lease that is existing has to be classified between the two kinds (International Accounting Standard 17).

The lessee is expected to present the accounting of the lease in the financial statements that are published once he or she acquires the asset being considered. The following is an illustration on how the lessee is expected to present the leases on the financial statements.

With regards to the operating lease, the rent payments are the ones that are presented. The journal entry is as follows:

Dr: Rent expense account

Cr: Cash account

With regards to financial leases, it is the lease obligation that is accounted for. The journal entry that is presented in financial statements is as follows:

Dr: Leased asset

Cr: Lease obligation

Problems Arising from IAS 17

IAS 17 which is lease accounting has constantly had problems arising within the accounting profession simply due to the way in which certain leases are accounted for in a company's comprehensive income state and/or the statement of financial position. The major problem is the capability to manipulate the financial statements of a company simply by falsely or inaccurately categorizing financial leases as operating leases which in turn results in off balance sheet finance. Another problem is that accounting for leases in IAS 17 complicates economic reality or actuality. This is for the reason that IAS 17 is in conflict with the accounting framework (IFRS, 2013). When it comes to operating leases, the only amount that is presented or displayed in the financial statements is the annual or yearly lease payments, which are actually charged to the statement of comprehensive income. On the other hand, for financial leases, the present value of the forthcoming or impending payments under the lease is presented or displayed as a liability and on the other side of the statement of the financial position on the right to the financial asset. There are examples or cases that take place where the items in the financial statements in accordance to the accounting framework ought to be reported in the statement of financial position but as a result of the contradiction or conflict that there is with IAS 17 they are not displayed or presented. One good example is the accounting treatment done for airplanes. Aircrafts as assets are not displayed on the statement of financial position for the reason that airplanes are not actually leased for their entire useable life. They are normally leased for just 7 years and for this reason have to be classified as operating leases. Nonetheless, the company that owns the airplane as an asset is mandated to make payments over the leasing period and the company is not able to escape from the lease as it is non-cancellable.

Changes proposed to IAS 17 by the Exposure Draft

Under the contemporary requirements in IAS 17, the accounting for any lease is reliant upon how it is classified. If a lease is classified as an operating lease then this amounts to the lessee not being expected to record or report any assets or liabilities in the balance sheet. This particular exposure draft that was published in May 2013 makes a proposal for changes so that there can be the removal of this dissimilarity or difference by having a requirement that lessees ought to make recognition of assets and liabilities for the obligations as well as the rights that are generated by the leases. These changes proposed will have an impact on lessor accounting and lessee accounting as discussed below.

2. Lessor Accounting

In practicality, the exposure draft would have a negligible or slight impact on the accounting by the lessor when it comes to financial leases. With regards to the IAS 17 standards, the lessor is expected to recognize a lease receivable and do the opposite which is derecognition of the underlying asset. Under the proposed model in the exposure draft, these would be deemed to be Type A leases and the lessors would have to apply the receivable and residual approach. Nevertheless, the residual asset would be comparatively minor. When it comes to leases which are classified as operating leases under IAS 17, the degree or level of change would be reliant on whether the underlying asset is real estate or equipment. A lessor would make distinction between majority of the equipment and majority of the real estate leases in the similar manner that a lessee would distinguish in accordance to the proposals made in the exposure draft. In accordance to the exposure draft, the operating leases of real estate would be classified as Type B leases and therefore the proposed lessor accounting approach would basically remain unchanged. On the other hand, operating leases of equipment or motor vehicles would characteristically be classified as Type A and for these kind of leases, the proposed changed would be substantial and considerable. When it comes to leases of equipment or motor vehicles, the lessor would make application of the receivable and residual approach which would encompass two aspects. The first one would recognize a lease receivable and also a retained interest in the residual asset and do the opposite to the underlying asset which is to derecognize it. The second aspect would be to recognize the amounting interest income on the lease receivable as well as the residual asset over the leasing period. A lessor who is a manufacturer or supplier may also make recognition of the profit on the lease when the lessee makes the underlying asset to be available for use (IFRS, 2013).

The exposure draft also lays down a number of exceptions. The exposure draft would allow simplified or basic accounting for leases that are for the short-term period which are leases whose leasing period does not extend 12 months. For these kind of leases, a company may choose on a class by class basis to undertake accounting in the similar manner as for operating leases according to the accounting standard. The exposure draft also makes proposals for a number of exceptions that are widely in accordance with the accounting standard for instance, leases for intangible assets and also leases for the exploration and also the usage of mineral resources and also parallel or similar resources that are non-regenerative. The association between the leasing approach and also IAS 40 which is for investment property also continue to be significant. With regards to the exposure draft, a lessee would be mandated to make use of IAS 40 when it comes to measuring right of use assets that are investment property and also select the cost model or the fair value model. This would alter the current status under which a lessee who has an interest for operating lease in investment property can also opt to make application of IAS 40 but the fair value of the asset has to be employed. On the other hand, a lessor who has the ownership of an investment property and then chooses to lease it under the grouping of a Type B lease would make application of IAS 40 when making considerations for the asset. With regards to disclosures, the standard that is proposed put forward comprehensive mathematical and narrative requirements for disclosure for the lessors and lessees purposed to help the users of financial statements to gain an understanding on the timing, the timing and also the ambiguity of the cash flows which arise from the leases. The exposure draft also makes the proposal of a modified retrospective model. Companies that make application of this model would employ particular easy calculations to originally measure assets and liabilities that are associated with leases. They also would have the ability to employ practice to make a determination of the period of the lease or whether a current contract encompasses a lease. Companies or establishments will change or modify the statement of financial position at the outset of the initial proportional time presented, as if the company had at all times made use of the proposed Standard. For finance leases prevailing at the date of original use, lessees and lessors will be allowed to employ the prevailing carrying amounts of assets and liabilities associated with leases as the original measurements with regards to the proposal made by the exposure draft (IFRS, 2013).

The Concept of Substance-Over-Form and how it relates to the Proposed Changes to IAS 17

The concept of substance over form is a concept for accounting which implies that the economic substance of financial transactions and occurrences have to be recorded in the financial statements and not just in their legal form so as to demonstrate or show a true and a fair perspective of the undertakings and dealings of the company. In essence, this concept encompasses making use of judgment when it comes those who prepare the financial statements so that they are able to develop the business aspect from the financial transactions or occurrences and to present them in financial statements in a way that best reveals their true nature. Even though the legal sides of the occurrences and the transactions are very significant and weighty, from time to time they have to be ignored or overlooked so as to offer more pertinent and valuable information to the users of financial statements.

The substance over form concept has been used widely and comprehensively in different international accounting standards as placed by the IFRS. In accordance to IAS 17 which encompasses leases, the accounting standard obliges the ones who prepare the financial statements to make consideration of the substance of the lease arrangements when they determine the kind of lease for the purposes of accounting. For instance, an asset might actually be leased out to a lessee without having the transference of the legal title at the culmination of the period of the lease. This kind of lease may, in substance, be taken into consideration as a finance lease if for example the period of the lease is considerably and significantly for the whole useful life of the asset or the lease contract authorizes the lessee to buy the asset at the end of the period of the lease at a very small price and it is most probable that this kind of an option will be applied by the lessee in such situations (Epstein and Jermakowicz, 2008).

The concept of substance over form greatly relates to the proposed changes made to IAS 17 in the exposure draft. The exposure draft goes in contradiction to the substance over form section of the International Financial Reporting Standards (IFRS). Companies which enter into lease contracts where the risks and the rewards of ownership are in actual fact not transferred choose to do so for the main reason of its convenience and flexibility and not for financial purposes. By itself, capitalizing the operating leases and accounting for interest would not amount to the substance of the operating leases being accounted for realistically. For example when accounting for funds, much consideration is placed in the substance of a transaction. With regards to the contemporary standards of recommended practice, a payment for a contract will usually be unlimited or unhampered income of the contributions but a funding for the supply of certain services will usually be deemed to be income that is unrestricted. Nevertheless, the exposure draft makes recognition of the importance of the substance over form and clarifies or elucidates that the income that is usually limited by the terms of the contract or agreement might be reported as being restricted in the financial accounts if the restraints are in substance the similar manner as would apply to a classified contribution or grant (IFRS, 2013).