Accounting for Leases

Essay topic: Accounting for Leases – the impact of AASB (IFRS) 16

Question You are required to write an essay to demonstrate your understanding of accounting for leases.

Answer

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Introduction to IFRS 16

The IASB has already published the regulations related to recognition of lease under IFRS 16 which would be the defining accounting standard for leasing effective from January 2019. All the companies which sees long term assets like machinery, equipment’s, offices and aircrafts etc. would come into its ambit and need to accept the provisions of the IFRS 16.

Under the existing rules for leasing lessee companies are required to account for eases either as operating or financial leases depending upon the tests conducted for determining them as such. While financial leases are shown in the books the operating leases are not shown as part of the financial statements. However, under the IFRS 16 rules all the companies would be required to show and recognize the equipment’s etc. as financial leases and all the leases would be needs to be shown in the books of accounts and thus the liabilities related to leasing would be greatly enhanced under the new IFRS regulations(Picker, 2015).

Question : Write an essay which examines accounting for leases, and the major expected changes that will come about with the application of the new leasing standard.

Answer Understanding of the operating versus financial leases

Under current financial standard in place companies recognize leases as either operating or financial leases. Under the operating method for leases the lessee company recognizes the lease rents paid as operating expenses in the period in which it is sued and thus ignores any lease payments expected to beamed in the future related to the asset as the ownership of the leased assets remain with the lessor and the lessee company would be required to return the asset to the lessor at the end of the period(Bascom & O'Donovan, 2017).

On the other hand, the financial ease is treated as a loan and thus the asset and the liabilities associated with this lease is shown in the balance sheet of the lessee. Under this the lease term is substantially bigger in relation to the life term of the asset a nd the lessee has the option of purchasing the asset at a value which is lower than the market price at the end of the lease period. unlike the operating lease the lessee bears the insurance costs and costs of maintenance of the asset in the leased period. Under this lease the lessee company would be allowed to claim both depreciation and interest paid as operating expenses. The  administrative expenses and running expenses would be expected to be on the higher side as well when compared to operating leases(Kieso, et al., 2016).
Impact of the new Standard (IFRS 16) for lessees and Lessors

IFRS 16 provisions require the lesseefirms  to recognize most leases on their balance sheets 9As financial leases) irrespective of the industry they are operating.

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Impact on Lessees

The new provisions which has kicked off form 1st January 2019 is expected to be critical for the companies categorized as lessees as the companies would be required to recognize liabilities arising or expected to arise of leases irrespective of whether they are operating leases or financial leases and thus the impact would be as follows:

a) All financial ratios estimated by companies including the gearing ratios, current ratios and EBIDTA, EBIT and Net income including the ROE and ROCE and cash flows from operating activities would be affected by new regulations(Carl S. Warren and James M. Reeve, 2012, 12th edition).

b) The reclassification of all the leases in the books would also be expected to impact the loan covenants, the credit ratings of most companies, borrowing costs would go up or down as per the new gearing ratio. As a result of the reclassification of all the leases in the books the leasing vs buying decisions might also get affected in a big manner as well.

c) As a result of reclassification of the leases in the financial statements the Balance sheet is expected to grow and the capital ratios would decline and gearing would increase. Also as a result of the reclassification the lease rent expenses would be replaced by the depreciation and interest expenses.

d) Those companies which are known to use big amount and long term assets in the category of real estates, aircrafts. PPE etc.are expected to be affected greatly since the liabilities would rise as the same would be recognized in the books. The Impact on companies using small value items (lower than $5,000 )on lease like personal computers and equipment’setc. would be on the lower side(Bascom & O'Donovan, 2017).

e) Most lessee companies would find it difficult and hard to comply with the provisions of the new standard since the same would increase the implementation cost would be on the higher side. Particularly those companies which does not have in house leasing system would be expected to incur higher amount for implementing the new standard.

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Impact on Lessors

Business and legal structures which supports the system of leases in the long term would be required to be reassessed to make sure the arrangements are effective.

The accounting pattern which is followed by the Lessor companies is expected to remain unchanged in the coming years but the lessor companies would be required to make change to make sure the behavioral changes as a result of changes for the lessee companies wont affect their business performance and earrings(Carl S. Warren and James M. Reeve, 2012, 12th edition).

Company chosen

The company which has been chosen for the discussion is BHP Billiton limited which is basically a mining and minerals company working predomantly in Australia and which has operations worldwide.

Types of leases listed in the books

The BHP Billiton company has shown both operating lease and financial leases under the heading of interest-bearingliabilities (notes 18)of the financial statement for the year ended 30th June 2018. As can be seen from the details provided the amount of the financial lases have increased in the 2018 Balance as compared to 2017. The financial leases which has been reported has been categorized as current and non-current liabilities.
Value of the leases listed in the books of the company

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The value of the leases which has bene reported under the financial statements of the BHP Billiton Limited is shown as under:

These financial leases used by the company is fully secured.

Finance leases of the company includes leases of power generation and transmission assets. The financial statementshas reported that some of the assets under use are subject to inflation escalation clauses. These financial leases also have renewal and extension clauses. the operating leases reported by the company includes assets such as property, plant and equipment’s. The lease rentals for operating leases are known but are subject to inflation clauses.
In the2017 FY the BHP Billiton has reported a lease rental of $391 million and the same for the FY 2018 has been $421 million. Operating leases have not been capitalized by the company and the amount of lease rents paid have been debited to the income statements on a SLM basis.

The Group’s commitments for capital expenditure both under financial lease and operating leases were US$2,110 million as at 30 June 2018 and US$2,084 million as of 30th June 2017. More than half of the same is assessed to have a life term of more than 5 years(AnnualReportBHPBiliton, 2017-2018).
Impact of the new Accounting standard on the Balance sheet/Financial statements of the company chosen

• Liabilities under the provisions of IFRS 16 would rise.

• The off-balance sheet items which are not shown in the books under the present regime (operating leases) would all be expected to vanish.

• The current year portion of the lease liability assessed would be treated as  a current liability and the same would impact the working capital and liquid ratios. If the leasedliabilities are increased by the conversion of operating leases to financial leases then the current ratio would decline so do the acid test ratios(Deegan, 2015).

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The income statement of the lessee companies would including the chosen company would be expected be as follows:

a) Under the new provisions the lease rents being paid by the lessee firm would be relaced by interest costs and depreciation expenses. The interest costs would be higher in the initial years and hence the impact would be higher in the initial period of conversion into the new standard.

b) EBIDTA and the Earnings before interest and tax (EBIT) is most likely increase for the lessee firm as the firm is not likely to use rental expenses and the same is replaced by interest costs and depreciation.

c) The operating cash flows for the lessee firm on account of lease rents paid would be replaced by financial cash flows on account of decline in the leasing liabilities and thus cash flows of the firm is likely to see moderate to drastic changes depending upon the volume and value of the lease obligations(Kieso & Wayangant, 2016).

Summary of the Short and Long term impact of IFRS 16

With the provisions of the IFRS 16 coming  into play in 2019 the followings would be affected:

1.EBIDTA and the Earnings before interest and tax (EBIT) is most likely increase for the lessee firm as the firm is not likely to use rental expenses and the same is replaced by interest costs and depreciation.

2. the current liabilities and current and acid-test ratios are likely to increase as some of the financial leases would be categorized as current liabilities.

3. the gearing ratios are likely to increase and capital ratios would be most likely to decline as operating leases would be classified as financial leases and thereby increasing the non-current liabilities.

4. while operating expenses are more likely to decline as operating lease expenses would decline , the interest costs are likely to rise and the same can eb expected to decrease the interest coverage ratios and thus financial risk is likely to increase.

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The provision of the new accounting standard IFRS 16 is not only expected to change  the way leases are accounted for in the books by converting the operating leases into financial leases but also it is expected that the companies and in this case BHP Billiton would be required to reassess the terms of the lease agreements.

It would also be required to reassess the terms of the agreements on the financial ratios and other metrics and likely to negotiate in keeping in mind the gearing ratio which is likely to increase with IFRS 16 coming into effect.

The Adoption of the provisions of the IFRS 16 will make sure the firms using lease needing more investment in the form of human resource which is trained to deal with new requirements, assess the but and lease conditions on a regular basis and also huge amount of technological resources. For example, companies working in the field of aircraft lease, telecom firms, retail and manufacturing firms would be required to make large scale adjustments for lease value calculations and make sure thy take the best decisions to reduce leasing related liabilities and expenses.

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