Introduction
IAS 17 regulates the accounting for leases; a lease is a contract whereby the supplier of an asset known as lessor conveys to the user of the asset known as lessee the right to use an asset for a specified period in return for periodic payments. In a leasing agreement, the lessor retains the legal ownership but conveys the lessee the right to make use of the asset for a specified period. Given the nature of leasing, that the lessee can use an asset without paying its full cost at once, it has become a preferred method of financing (BPP, 2010). Leasing is popular because the lessee may find tax relief on lease payments advantageous, secondly, leasing may be cheaper than a bank loan. Thirdly, if the lessee cannot raise enough funds to buy the asset required or it is difficult to get a bank loan then the lessee can rent it to be able to use the asset. On the other hand, the lessor may find leasing attractive because once the purchase of the asset is complete at the inception of the lease the asset is handed over to the lessee and therefore relieved of further financial concern on the asset while at the same time making a return out of the payments made by the lessee.
Key features of current IAS 17
IAS 17 standardizes and prescribes the appropriate accounting treatment and disclosures to apply in relation to assets held under lease in the financial statements of both the lessor and lessee. The standard defines a lease and classifies leases into financial and operating leases. As mentioned above a lease is a contract between a lessor and a lessee for use of an asset in return for regular payments for a specified period. A finance lease is one that confers nearly all the rewards and risks of the title of an asset from the supplier to the lessee. (BPP, 2010). It usually covers almost all of the asset’s life. On the other hand, in an operating lease, the supplier of the asset retains most of the rewards and risks of ownership and the period of the lease is short compared to the expected economic life of the asset. For a lease to be classified as a finance lease one of the following conditions must be met. One of the conditions is that at the initiation of the lease, the total sum of the present value of the minimum lease payments is supposed to be larger than or equivalent to the fair value of the asset. Moreover, the lease should contain a deal purchase option that is so attractive that it is very much probable that it will be taken up. Additionally, the title of the asset will be conveyed to the lessee at the end of the lease term. If the lease is for the main part of the financially viable life of the asset then the lease is classified as a finance lease. To add on to that if the leased asset is of such a specific nature that it is only the lessee who can use it without modifications it qualifies the lease to be a finance lease. Another provision for a lease to be categorized like a finance lease is if the contract is terminated, the lessee bears the supplier’s losses. For a finance lease after the primary lease period, the lessee has the option to continue using the asset at a rent that is below market rate (Mackenzie, Coetsee, Chamboko, & Colyvas, 2011).
IAS 17 goes ahead to prescribe the different accounting treatments and presentations in the financial statement for finance and operating leases. Payments made to the supplier of the asset under operating leases are expensed in the income statement with no inclusion in the statement of financial position only a note of the financial obligations of the lease is made. Conversely, finance leases are included in the statement of financial position. The asset is capitalized and shown as a long-term asset under property plant and machinery on the asset side. On the liability side, the finance lease is divided into three; short -term debt, which is the portion payable within twelve months, interest payable based on accrual accounting and long-term debt for the portion payable after twelve months (Melville, 2009). While the lessor recognizes a receivable in the statement of financial position at an amount equal to the net investment in the leased asset under finance lease with finance income from the rental payments going to the statement of comprehensive income. IAS 17 further prescribes that the lease earnings are to be acknowledged on a straight-line method or any other efficient method in the statement of comprehensive income under an operating lease. The following illustration shows how a company with finance lease obligations would present the lease.
Illustration from Published from Published Financial Statements (Lis Plc)
Financial Statement Extracts
For year ended June 30th 2010
- Statement of comprehensive Income (extract)
- Depreciation on leased assets – 17,900 $
- Finance costs – 8,564 $
- Statement of financial position (extract)
- Non-current assets
- Leasehold assets – 68,400 $
- Non-current liabilities
- Finance lease liability – 56,358 $
- Current liabilities
- Finance lease liability – 18,240 $
- Non-current assets
Development of the Existing IAS 17
IAS 17 was introduced because the earlier standard concealed the true nature of lease transactions in the financial statements. Companies effectively owned an asset and had a liability in the form of a debt, but neither the asset nor the liability was shown in the statement of financial position. This meant that the supplier of the asset would record the asset that may never be used in business by the lessor as a non-current asset while in the real sense the asset is a stream of cash payments made at specified intervals (Mirza, Holt, & Knorr, 2011). The lessee in reality had acquired a non-current from which future economic benefits would flow to the firm perhaps for many years but not reflect it in the financial statements. This resulted in off-balance sheet financing. Off-balance sheet finance is funding the operations of a firm or the acquisition of an asset in a manner that under legal requirements some or not all the finance may be shown in the statement of financial position.
The accounting framework requires that dealings should be presented in harmony with their economic essence and reality and not merely their lawful structure. IAS 17 was developed with the intention to avoid misinterpretation by users of financial statements since the position of the company would ne misstated and therefore misleading to the users of the accounts. In the view of the foregoing, IAS 17 explicitly requires the lessee to recognize the asset in the statement of financial position since risks and rewards incidental to the ownership of an asset are substantially transferred from the lessor at the inception of the lease and recognize the amount due to the lesser as a liability (Weetman, 2007).
Criticisms of IAS 17
IAS 17 has received a lot of criticism from financial accountants and accounting professional bodies alike. The different accounting and presentation of operating and finance leases has led to designing lease agreements in such a manner that what is economically and in substance a purchase be accounted for as an operating lease and therefore reduce gearing as the debt arising from the lease contract is not shown. The contract would then be renewed after expiry allowing the lessee the use of the asset for its major economic life without recognizing it. Other deficiencies and criticisms of IAS 17 revolve around interest rate implicit in finance lease, contingent rentals, and joint lease contracts for land and buildings and lease of investment property. Contingent rentals are not included in the calculation of present value of the minimum lease payments this gives room for creative accounting because it may result in a finance lease being classified as an operating lease. The current existing IAS 17 requires a division between the land factor and the buildings part in accounting for long-term land and buildings lease agreements. Land having a limitless economic valuable life is classified as operating lease while the buildings as finance lease if the lease contract is for the main portion of the buildings economic life. This has created a lot of debate over the years for land and buildings lease contracts that do not pass the land title to the lessee.
Additionally IAS 17 does not allow investment property under lease to be classified as finance lease but as operating lease. This means that the property would not be shown in the non-current assets while in essence the lessee has the property that has been sublet to another party. Another deficiency of IAS 17 is how to account for sale of capacity contracts like the ones commonly found in the telecommunications industry where a company sells a certain amount of its network capacity to another company for a specified period. The standard does not state whether this capacity ought to be derecognized from the statement of financial position and it does not stipulate the period in which the income from the capacity let should be recognized. IAS 17 does not explicitly describe how sale and leaseback contracts with the opportunity of repurchase ought to be accounted for. Under this arrangement, the lessee retains control of the asset due to the repurchase option and so the standard does not clearly state how to account for such a lease. IAS 17 states that operating lease ought to be expensed on a straight-line basis over the lease period except if a different technique is more fitting in representing the time pattern of the usage of the benefits. The standard does not give alternatives to the straight-line method therefore leaving a loophole for creative accounting.
Conclusion
In the view of the discussed criticisms and deficiencies, the IASB has seen the need to review IAS 17 to harmonize the accounting for leases in a more refined comprehensive manner with little room for creative accounting. IASB has responded to most of the criticisms and deficiency questions arising and soon a revised IAS 17 will be ready for implementation.
Reference List
BPP. (2010). Corporate Reporting. London, BPP Learning Media Ltd.
BPP. (2010). Financial Reporting. London: BPP Learning Media Ltd.
Mackenzie, B., Coetsee, D., Chamboko, R., & Colyvas, B. (2011). Wiley Interpretation and Application of International Financial Reporting Standards 2011. Toronto, Wiley.
Melville, A. (2009). International Financial Reporting: A Practical Guide, 2nd Edition. Chicago,Wiley.
Mirza, A. A., Holt, G., & Knorr, L. (2011). Wiley IFRS: Practical Implementation Guide and Workbook. Chicago, Wiley.
Weetman, P. (2007). Financial and Management Accounting: An Introduction. Chicago, Prentice Hall.