Detailed Report: Evaluating the Shift in Lease Accounting Practices

This report provides an in-depth evaluation of lease accounting practices, comparing existing rules under IAS 17 and ASC 840 with the new standards introduced by IFRS 16 and ASC 842. It discusses the background and criticism of existing accounting rules, highlighting the shift in focus from 'w...Read More

The Leasing – Final Paper
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Introduction
Evaluation of lease – existing practices1
IAS 17 – Leases and ASC 840:
IAS 17 – Leases deals with the following aspects in respect of leasing –
 Recognition;
 Measurement;
 Presentation; and
 Disclosure
Existing Rules for dealing with ‘Leasing’ Transactions:
As per the IAS, leases are required to be classified as either finance lease (capital
lease in case of ASC – 840) (which transfers substantial risks and rewards of
ownership, and directs for recognition of assets and liabilities in the books of
accounts of the lessee and a corresponding receivable in the books of accounts
of the lessor on the name of lessee) and operating leases (which results in
recognition of lease rentals payable in the books of accounts of lessee as
expenses, while the asset remains in the books of accounts of the lessor). In
short, in case of finance lease, the lessee should capitalise the asset under the
lease agreement in the books of accounts, while creating the corresponding
liability also. On the other hand, in case of mere operating lease, the lessee is
not allowed to capitalise the asset under lease agreement in its books of
accounts.
Indicators for classification of lease as ‘Finance Lease’:
In order to determine whether a particular lease agreement between the lessor
and lessee is in nature of operating lease or financing lease, the substance of the
transaction should be considered over its form. Situations that normally lead to a
lease being classified as a finance lease include the following ("IAS 17 — Leases",
1994):

 Transfer of ownership of the asset to the lessee at the end of the lease
term;
 The lessee has been given an option to acquire the asset under
consideration for lease at a price which is expected to be substantially less
than the fair value of such asset at the time of exercise of option and at
the inception of the lease term, the lessee is reasonably expected to
exercise the option at the expiry of the lease term;
 The lease term covers the substantial portion of the useful economic life of
the asset (at least 75%, in the case of ASC 840) even though the title is
not transferred at the end of the lease period;
 At the inception of the lease period, the present value of the minimum
lease payments amounts to at least substantially all of the fair value (at
least 90% of the fair value of the asset in the case of ASC 840) of the asset
under consideration for the lease; and
 The leased assets are of special nature such that no person other than
lessee can use the asset without substantial modifications to the existing
asset.
Some other indicators which can result in classification of the lease as finance
lease as per IAS 17 are as follows:
 The terms of lease agreement contains a clause where the lessee should
bear the losses incurred by the lessor owing to cancellation of lease;
 Gains or losses from fluctuations in the fair value of the residual fall on the
lessee; and
 The lessee has the ability to continue to lease for a secondary period at a
rent that is substantially lower than market value.

If any of the above said conditions exists in the terms of lease agreement, then
the lease may be classified as a finance lease.

New Lease Accounting Rules
Background – Criticism on existing Accounting Rules for leasing:
The SEC after thorough investigation into the biggest scams involving ‘Financial
Reporting’, it uncovered a loop hole in preparation and presentation of financial
statements: operating lease. Critics argue that the different accounting
treatments available for recording and presenting the operating lease
transactions make it challenging for the investors (even professionals and Wall
Street analysts after all the years of experience and their expertise) to get an
understanding of the overall debt obligation of the company in real terms, many
times overestimating the liability from these transactions. In other words, due to
existing accounting rules, the company has no obligation to report assets and
liabilities arising out of operating lease in the balance sheet and the companies
used to disclose the same in the notes to the financial statements. This results in
availability of inaccurate data regarding company’s outstanding expenses and
the users of financial statements are forced to estimate the off balance sheet
obligations which often resulted in over estimation of such obligations. This was
a serious threat for true and fair view of financial statements. Therefore SEC
directed Financial Accounting Standards Board (FASB) which is assigned with the
responsibility of creation of standards for US GAAP to co-ordinate with the
International Accounting Standards Board (IASB) in preparation of a new, globally
accepted and easily convergeable standard for recording, presenting and
disclosing the leasing transactions. As a result both the bodies have prepared
two, partially converged standards. FASB has introduced ASC 842 to replace ASC
840 and IASB has introduced IFRS – 16 to replace IAS – 17 ("FASB, IASB Revised
Proposals Would Cause Significant Lease Accounting Changes", 2019).

Summary of New Rules:
The most important change which will create impact on the figures of financial
statements lies in bringing the operating lease onto the balance sheet (2019). This
was made possible by shifting the focus for classification of lease from ‘who
bears the risk’ to ‘who has right to use the asset’. By recognising asset under
operating lease in balance sheet, the IFRS – 16 as well as ASC – 842 eliminated
the difference between operating lease and financial lease. Therefore a new
lease asset (representing the right to use the leased asset during the period of
lease) and the lease liability (representing the obligation for payment of lease
rentals during the period of lease) based on the discounted payments of lease
rental required under the lease, taking into consideration, the term of lease as
determined under the new standard (Leases (Topic 842) Targeted Improvements, 2019).
Further the new standard classifies leases as Type A and Type B. Leases of
personal property (say vehicles) would have accelerated or front-loaded expense
on the income statement and is called as Type – A leases while leases of real
property (say buildings) may have straight - line expense in the income
statement and hence called as Type B Lease. Therefore the determining factor
for classification of lease as Type A or Type B is the pattern of consumption of
leased asset by the lessee during the tenure of lease (Azih, 2019).
Result of application of new standards:
The main objective of application of these new rules for accounting for the lease
transactions is improved comparability and transparency on the balance sheet.
The users of the financial statements can make an informed decision making
since they can clearly understand the existing obligation and potential impact of
these transactions on the overall financial position of the company more
accurately. The leasing industry is going to be affecting the most with the

introduction of the new standard. Further, industries which are capital intensive
where the companies resort to leasing to procure costly equipment will also
experience the impact of the new standard. For example, the balance sheets of
airlines, retailers, banks, restaurants and telecom companies will experience
huge variations ("FASB Issues Lease Rules; Will Have Big Balance Sheet Impacts", 2019).
Impact of new accounting rules on financial reporting:
The potential impact of the adoption of new accounting standard for leasing
transactions are as follows:
Impact on figures in Financial Statements and Key Financial Metrics
("Accounting for Leases IFRS 16 vs IAS 17 - TFA Geeks", 2019):
As the operating lease will be capitalised, there will be shift in financial metrics
for companies which are involved in large number of this type of lease
transactions. Possible changes include:
Increase in –
 Liabilities – since the discounted value of lease payments to be made will
be recorded as an established obligation;
 Reported debt – since the payments that fall due within company’s
succeeding operating cycle will be presented as current payable in the
balance sheet;
 Recorded Assets – Since the right to use the asset is quantified and
recorded as asset in the Balance sheet;
 amortization – owing to increase in the value of recorded assets;
 Cash outflows from financing activities;
 EBITDA – Since the lease payments are treated as settlement of debt
rather than expense; and

 EBIT – Since the increase in EBITDA in turn increases the EBIT.
Decrease in –
 Asset Turnover – Since the numerator and denominator increases by same
amount;
 Equity – since a new liability is created which reduces the net assets of the
company;
 Operating cash outflows; and
 Operating expenses – since the lease rentals paid are treated as
settlement of debt rather than an expense.
This will lead to possible inflation of Balance sheet ("New FASB Lease Standard Could
Inflate Balance Sheets", 2019).
Impact on Shareholders:
With the changes in financial metrics and figures in financial statements, there
will be an impact on the market capitalization of assets and therefore the value
of share also.
Impact on Presentation of Financial Statements:
Balance Sheet:
The asset side of the balance sheet will have a new line item ‘Operating lease
right-to-use assets’ and the liabilities side of the balance sheet will have a new
line item ‘operating lease liability’
Income Statement:
A separate line item to record lease expense (which includes both amortization
expense and interest expense should be created).

Cash flow Statement:
The lease payments are to be split between the principal portion and the interest
portion.
Impact on Disclosures:
The company should make the following additional disclosures:
 Future minimum operating lease payments;
 Cost of operating lease obligation;
 Present value of operating lease obligation; and
 Implied interest of Operating lease obligations
Impact on Taxes:
Usually, the new standard does not change the treatment of leases for income
tax purpose. Therefore the company will not create the operating lease asset for
tax purposes and continue to treat the lease payments as expenses. The
difference in treatment for the purpose of accounting and tax results in
temporary timing differences resulting in deferred tax assets and liabilities ("New
Leasing Standards Affect Financial Statements : CliftonLarsonAllen (CLA)", 2019).
Conclusion:
While the adoption of new standard will definitely enhance the overall
comparability of the financial statements, there are some challenges to be
addressed by the companies in adoption of the new standards. The first and
foremost problem will be identification of assets falling under operating lease,
their valuation and recording their corresponding assets and liabilities in the
balance sheet (Who is Most Impacted by the New Lease Accounting Standards, 2019). Further
since the standard will have substantial impact of the financial statements of
company with lot of transactions involving operating lease, the shareholder and
other stakeholders will experience major deviation from their expectations
regarding the performance of the company and hence all the material facts and
the impact of the new standard on various figures of the financial statements are

to be clearly and carefully disclosed ("New lease accounting standards will affect your
financial reports – Maryland Daily Record", 2019).
Bibliography:
IAS 17 — Leases. (1994). Retrieved from https://www.iasplus.com/en/standards/ias/ias17
FASB Issues Lease Rules; Will Have Big Balance Sheet Impacts. (2019). Retrieved from
https://www.bna.com/fasb-issues-lease-n57982067931/
FASB, IASB Revised Proposals Would Cause Significant Lease Accounting Changes. (2019).
Retrieved from https://www.bna.com/fasb-iasb-revised-n17179874062/
New lease accounting standards will affect your financial reports – Maryland Daily Record. (2019).
Retrieved from https://thedailyrecord.com/2018/01/19/new-leas-accounting-standards-bryan-c-porter/
New FASB Lease Standard Could Inflate Balance Sheets. (2019). Retrieved from
http://www.cfo.com/accounting-tax/2016/02/new-fasb-lease-standard-inflate-balance-sheets/
Accounting for Leases IFRS 16 vs IAS 17 - TFA Geeks. (2019). Retrieved from
http://tfageeks.com/accounting-leases-ifrs-16-vs-ias-17/
New Leasing Standards Affect Financial Statements : CliftonLarsonAllen (CLA). (2019). Retrieved
from https://www.claconnect.com/resources/articles/2018/new-leasing-standards-may-affect-financial-
statements
lease accelerator. (2019). Who is Most Impacted by the New Lease Accounting Standards [Ebook].
Retrieved from https://explore.leaseaccelerator.com
Financial Accounting Standards Board. (2019). Leases (Topic 842) Targeted Improvements [Ebook].
Retrieved from https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?
cid=1176170977888&acceptedDisclaimer=true
(2019). Retrieved from https://www.pwc.com/gx/en/services/audit-assurance/assets/ifrs-16-new-
leases.pdf
Azih, G. (2019). Type A & Type B Leases under New Lease Accounting Rules | LeaseQuery.
Retrieved from https://leasequery.com/blog/type-a-type-b-leases-under-new-rules/