Accounting Theory and Contemporary Issues

This report conducts a critical evaluation of AASB 117 and its drawbacks, discusses the requirement for change, and highlights the changes incorporated in the new accounting standard AASB 16. It also explores the impact of changes in lease standards on entities with significant lease financing and the tendencies of entities to classify lease contracts as operating. The report further analyzes the implementation of IFRS 16 and its expected impact on comparability among companies. Subject: Accounting, Course Code: N/A, Course Name: N/A, College/University: N/A

Running head: ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Accounting theory and contemporary issues
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1ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Abstract
The report will conduct critical evaluation of AASB 117, its drawback and the requirement for
change. It will highlight the changes incorporated in new accounting standard AASB 16 and
impact of changes in lease standard on the entities those have significant level of the lease
financing. The report will find out the reasons behind the tendencies of the entities to classify
the lease contracts as operating. It is said that the implementation of IFRS 16 is expected to
improve the comparability among companies who lease the assets and who borrows to buy
asset and this statement will be analysed in the report. It will further state the Impact on
leasing market owing to application of AASB 16 and key disclosures provided by Rio Tinto for
transition to AAASB 16 from AASB 117.

2ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Table of Contents
Introduction.................................................................................................................................3
Critical evaluation of AASB 117 and its drawback......................................................................3
Requirement for change.............................................................................................................4
Changes incorporated in new accounting standard AASB 16....................................................4
Impact of changes in lease standard on the entities those have significant level of the lease
financing......................................................................................................................................5
Tendencies of the entities to classify the lease contracts as operating.....................................6
Implementation of IFRS 16 is expected to improve the comparability among companies who
lease the assets and who borrows to buy asset.........................................................................6
Impact on leasing market owing to application of AASB 16.......................................................7
Key disclosures provided by Rio Tinto for transition to AAASB 16 from AASB 117..................8
Conclusion..................................................................................................................................8
Reference....................................................................................................................................9

3ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Introduction
Before issuing the new standard IASB considers costs and the benefits associated with
the new requirements. This consideration includes assessment of impacts on the costs for
both the users and the preparers of the financial statement. Further, the comparative
advantages that will gain by the preparers in developing the information that would have
otherwise charge the users in estimating the same. New lease accounting that is AASB 16
will overwrite the existing lease standards AASB 117 and the new lease accounting is
expected to deliver the stakeholders and investors with more transparent view for the financial
position of the entity. To adopt the new standard effectively they will require developing the
forward strategic path. It will require the entities to transform radically regarding how they will
account for lease (Barone, Birt and Moya 2014)
Critical evaluation of AASB 117 and its drawback
The primary objective of AASB 117 was to prescribe the appropriate accounting
standards for lessors and lessees and the disclosures applicable to lease. As per AASB 117
the leases were to be classified on the basis of the extent to which the rewards and risks
associated with the ownership of leased asset will lie with the lessee and lessor. Lease
classified as the finance lease if considerably all the risks and rewards associated with the
ownership is transferred. On the other hand, the lease is considered as operating lease if
considerably all the risks and rewards associated with the ownership are not transferred
(Rapoport 2013). Whether the contract will be considered as the finance lease or operating
lease depends on substance of transaction and not on the form of the contract. However
owing to various drawbacks associated with the old lease accounting the accounting
standards board felt it necessary to change the old standards and introduce the new
accounting standard AASB 16. Various drawbacks are as follows –
 As per the old accounting standards the difference among capital leases and capital
assets are included under the balance sheet. The operating leases are recorded as an
expense under the income statement and the capital leases are not reported.
 The difference between finance lease and operating leases were not made. Hence,
using the same as an opportunity most of the entities used to omit the lease from their
balance sheet that in turn misstates the financial position of the company ( Aasb.gov.au
2019).
 As the future payment for the operating lease are not reported in the financial
statement of the entity it create major difference between the amount reported by the
entity under lease and the actual lease obligation.
 It used to recognize the depreciation associated with lease assets and the interest on
account of lease liabilities under the income statement over the term of lease
 It separates the amount cash paid into the principle amount that is involved with
financing activities and the interest that is generally presented within the financing or
operating activities under the cash flow statement (Aasb.gov.au 2019).
Hence, for removing such issues AASB decided to issue the new lease accounting
standard AASB 16 that will help in presenting the financial statements in more transparent
way which in turn will facilitate the users in making decisions.

4ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Requirement for change
Owing to wide range of concerns highlighted by US Securities Exchange Commission,
users of financial statements and stakeholders the FASB as well as IASB converged for
initiating lease project. Existing lease standard was disparaged owing to failing in providing
faithful representation in financial statement as the users were not able to gain full picture of
financial position of the entity’s leasing transaction. Apart from that, in the year 2005 SEC
informed that leasing obligations in financial statement are not presented in transparent way
that led to off balance sheet activities engagement by the entities. The off-balance sheet
commitments associated with lease as per AASB 117 resulted into significant absence of the
information that allowed the listed entities to disclose approximately US$ 3 trillion during the
year 2014. Hence, to cease the controversies it was required to introduce the new accounting
standard for lease that is AASB 16 (Wong and Joshi 2015).
Apart from the above, when any entity reports the operating lease in its financial
statement it is obliged to estimate the future obligations in compliance with future payment
that comes under future lease arrangements. Though the same is not reported by the entity in
its balance sheet, the obligation actually exists and it misstates the users. Further, as per the
requirement of AASB 117 the entity is required to report the liability is association with
operating lease in the statement of profit and loss statement. As the difference between
finance lease and operating leases are not made, entities used to omit the lease from their
balance sheet that in turn misstates the financial position of the company. Further, as the
interest obligation that is generally presented within the financing or operating activities are
presented under the cash flow statement, the profit of the entity will be misstated (Laing and
Perrin 2014).
Hence, for eliminating these issues AASB decided to issue the revised lease
accounting standard AASB 16 that will help in presenting the financial statements in more
transparent way which in turn will facilitate the users in making decisions. It will further help
the entity to present the financial statement to be presented in true and fair manner.
Changes incorporated in new accounting standard AASB 16
New AASB 16 for lease is expected to have considerable impact on financial statement
of different businesses while it will be applied. AASB made significant changes to the lease
accounting with the introduction of AASB 16 with the most significant change being removal
of distinction among operating lease and financial lease. It will bring most of leases under the
balance sheet. New accounting standard will significantly have potential impact on the entities
that may not seem obvious at the 1st sight immediately. AASB 16 is expected to have impact
on almost all the businesses at least to some extent. The major thing is that with new
standard the entities need to be proactive and must be prepared (Aasb.gov.au 2019). As per
the existing accounting standard obligation for making future payments under the operating
lease arrangement are not reported in the balance sheet even when the entity is committed
for the future expenses. Concern of various stakeholders is that this will not provide accurate
reflection of company’s actual financial position. Changes in the accounting standard will lead
to inclusion of lease liability and the right of use the asset under the balance sheet. To be
stated differently, the business will include the cost for using the leased assets and
associated benefits under the balance sheet (Aasb.gov.au 2019). However, some downsides
are there with the new standards as follows –

5ACCOUNTING THEORY AND CONTEMPORARY ISSUES
 Changes will increase level of the financial and commercial reporting risk substantially
with the increase in complexity as well as hidden issues that may generate while
implementing new standard.
 New standard will change the expense profile. Instead of being the straight line rental
expenses, more expenses will be there during early years and less expenses in the
later years.
 It will potentially cause large increase in the metrics like EBITDA. Instead of the
operating rental expenses, there will be movement of the expenses below the EBITDA
line that has wide range of associated issues.
 The mismatch may potentially results into issues associated with the working capital
with the funding of non-current assets for partly current liability (Aasb.gov.au 2019).
Impact of changes in lease standard on the entities those have significant level of the
lease financing
In accordance with AASB 117 the lease is considered as operating lease if does not
qualify to be treated as finance lease and the monthly payment associated with the same are
reported as the expenses under the profit and loss statement. However, in accordance with
AASB 16 the treatment for operating lease will considerably change. Lease with less than 1
year have the option to chose the accounting policy if it does not want to recognise the liability
or asset. However, for the leases with the period of more than 1 year period shall be reported
as right-to-use asset under the entity’s balance sheet and the liability associated with the
same will be generated as for payment of rent. The payment will be the payment that is to be
paid under optional period for renewal in case the lease is convincingly certain regarding
exercise of lease extension. Further he assets and liability both is required to be measured at
the present value of initial lease payment (Xu, Davidson and Cheong 2017). Present value
here is to be calculated by applying the implicit discount rate or incremental rate of borrowing
for lessee. Liabilities will be reduced and assets will be depreciated for the value of lease
payment obligation. However, associated parties with the lease and the monthly lease
obligation it is required to establish that lease arrangement is made on monthly basis actually.
Long term leases are indicated through the following –
 Lessee is sole user for right-to-use asset and provides the requited amount of cash
flows t the lessor that will provide the debt service
 Leases will make significant improvement in the property and the same will be
depreciated over the time period of more than 12 months
 Lessee will provide the guarantee on account of debt to lessor.
 Economically it will be disruptive for the lessee to relocate new facility (Aasb.gov.au
2019).
In case the criteria mentioned above does not meet the lease will be reported on
monthly basis and will be recognised as right-to-use asset and the entity will further report the
liability associated with the same. AASB 16 will further require the additional disclosures in
context of qualitative and quantitative aspects that will change the financial ratios of the entity
and other financial measures those care used for analysing the company’s performance.
Further, AASB 16 will alter the certainty with which the costs associated with lease are
reported (Bozzolan, Laghi and Mattei 2016).

6ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Tendencies of the entities to classify the lease contracts as operating
When the lease is regarded as the finance lease the entity is required to report both
lease assert and lease liability under its financial statement at fair value or at present value of
MLP (minimum lease payment) whichever is lower. It will adversely impact the leverage ratios
of the entity as the financial liabilities will be increased; current ratio will be reduced as current
lease liabilities will be increased without addition to the current assets, asset turnover will be
reduced as the lease assets will be recognised as part of the total assets and interest
coverage ratio will be reduced as EBITDA will be increased with increase in the interest
expenses. Changes in the ratio will however depend on characteristics of lease portfolio. In
addition to that in the initial years of lease the expenses will be significantly high. Hence, this
will be of significant concern for the entities and hence the entities will prefer to treat the lease
as operating lease and not as finance lease (Joubert, Garvie and Parle 2017).
Positive accounting theory predict the behaviour of the personnel in context of
accounts through scrutinizing the scenarios with regard to what actually happened and
relevance of particular situation. It is found that generally the managers arrange for the lease
contracts with lessor and transfers the lease contract from finance lease to the operating
lease. Finance lease capitalisation will significantly impact the reported accounting data that
will have impact on the managers as well as the shareholders. However the lease treated by
managers will mis-direct the financial statement financial statement users those take
important decision on the basis of the financial statements. Therefore, it can be stated that the
practises used by the managers in terms of lease accounting will violate positive accounting
theory (Sieverding 2018).
Implementation of IFRS 16 is expected to improve the comparability among companies
who lease the assets and who borrows to buy asset
It is expected by IASB that the comparability of financial information will be improved
significantly through the application of IFRS 16. Major reason for that are listed below –
 The companies will report the assets and liabilities, whatever applicable for all the
assets.
 All the lease assets and lease liabilities will be measured using the same
measurement approach.
 The obtained rights and incurred liabilities will only be measured for those which are
associated with lease (Dakis 2016)
In response to the aforementioned facts different entity’s financial statement will reveal
different operating decisions. Though lease is similar in economic context irrespective of the
fact that the money is borrowed for buying the asset or leasing the asset, the sum revealed in
consistence with IFRS 16 will be same with the amount that would have been reported if the
entity chooses borrowing to buy the asset. However, in economic context the lease vary from
borrowing to buy the asset. For example, if the company taken on lease new asset for 7 years
amount that will be recognised is in compliance with IFRS 16 and will reveal different
decisions in economic context. Asset as well as liabilities will be recognised in the balance
sheet at lower amount as compared to the amount that would have been reported by the
company if it borrows the amount to buy the asset. Under this situation, entity’s right to utilize
the asset for a long time is fundamentally unique when contrasted with the right that would
have been obtained if the organization would have bought the asset (Brumm and Liu 2019).

7ACCOUNTING THEORY AND CONTEMPORARY ISSUES
Example – estimated effect on 2 companies dealing with heavy machines and uses the plant
equipment and property intensively are presented below. Company B leases 70% of
machinery whereas company A leases 20% of the equipment. Information those are used by
the investors as well as analysts includes long term liabilities, total assets and total equity
(Svoboda and Bohušová 2014) These metrics can be affected significantly if the entity is
engaged in off balance sheet arrangements –
Company A (leases 20% of
machineries
Company B (leases 70% of
machineries
Reported in
balance sheet
(IAS 17)
All leases
reported in
balance
sheet (IFRS
16)
Reported
in balance
sheet (IAS
17)
All leases
reported in
balance sheet
(IFRS 16)
Property, plant and
equipment
16,9
08.00
19,92
6.00
15,74
8.00
24,0
20.00
Long term liabilities
13,2
32.00
16,56
7.00
9,61
5.00
18,3
20.00
Equity
6,7
19.00
6,40
2.00
5,60
4.00
5,1
71.00
Ratio of long term liabilities
to equity 2.0:1 2.6:1 1.7:1 3.5:1
From the table presented above reveals the figures reported by both the entities varies
as one company reported as using IAS 17 and another company reported as per IFRS 16.
Amount reported as per IAS 17 is signifying that company A has high assets base and high
financial leverage whereas company B has lower high assets base and high financial
leverage. However, in reality the position is opposite and will be held good if the off balance
sheet items are considered while preparing the statement. Applying IAS 17 where lease
information will not allow the investors to compare the plant, machinery and property (Song
2016)
Impact on leasing market owing to application of AASB 16
IFRS 16 focuses on the fact that whether the behavioural changes will have any impact
on the leasing market. For example, as IFRS 16 improves that comparability among the
entities those leases the asset and those borrow money for buying the asset the entity may
prefer to buy the asset rather than taking the same on lease. Further, it was also be
considered by the IASB that whether IFRS 16 will leave any scope to earn incentives on
achieving any desired result (Morais 2013). For example with reduction in the lease liability
and making the lease term shorter lease payment will be variable and lease liabilities will be
recognised for shorter term of leases. IASB further mentioned in contrast of these facts that

8ACCOUNTING THEORY AND CONTEMPORARY ISSUES
lease will continue as there are number of benefits associated with lease those cannot be
ignored. One such benefit is that it provides finance where the same is declined by
commercial bank. Hence, even if the entity buys some of the asset still will lease some of the
assets. Hence, AASB 16 will not be able to significantly impact the leasing market ( Krische,
Sanders and Smith 2013)
Key disclosures provided by Rio Tinto for transition to AAASB 16 from AASB 117
Impact on the entity for the transition to accounting pronouncement that is mandatory
from 2019 is expected to be material. The entity will implement the new standard that is AASB
16 from 1st January 2019. For transition, as it is permitted by the IFRS 16, the entity will apply
modified and retrospective approach to the existing operating lease that will be capitalised as
per new standard (Riotinto.com 2019). For the existing finance lease, carrying amount before
the transition will be represented the values at 31st December 2018 that is allocated to right-
of-use assets and the lease liabilities (Schelle and Baltussen 2013).
(Source: Rio Tinto annual report 2018, Pg – 150)
Conclusion
From above discussion it is concluded that owing to various drawbacks associated with
the old lease accounting the accounting standards board felt it necessary to change the old
standards and introduce the new accounting standard AASB 16. Changes in ASB 16 will
provide more accurate representation regarding the financial position of business through
reflection all the liabilities fully and providing more useful data under the financial reporting for
the shareholders and investors. Further, IASB expects that the comparability of financial
information will be improved significantly through the application of IFRS 16 as the companies
will report the assets and liabilities, whatever applicable for all the assets. Further, all the
lease assets and lease liabilities will be measured using the same measurement approach.

9ACCOUNTING THEORY AND CONTEMPORARY ISSUES
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10ACCOUNTING THEORY AND CONTEMPORARY ISSUES
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