Intermediate Accounting 2 Assignment

• Background and overview

In 2005, there is roughly US$1.25 trillion of off balance sheet leases estimated by the US Securities and Exchange Commission (SEC) due to the application of IAS 17 which allows the lessees not to report operating leases on companies’ balance sheet. In IAS 17, lessees will classify some lease assets as operating assets and they do not show any asset or liability in balance sheet. However, some operating leases may be non-cancellable, which actually represents a liability and should be reported. Since the information accuracy and transparency are essential to help investors make decisions, the International Accounting Standards Board (IASB) has developed a new leases standard, IFRS 16 which will be effective on 1 January 2019, to supersede IAS 17. I would like to first compare the differences between IFRS 16 and IAS 17 and explain how new standard address the problem of old standard with supported example. The implications of new standard and conclusion will be given after comparisons.

• Effects on changes to the accounting requirements

• Analysis for lessee

In IFRS 16, lessee accounting has changed substantially while lessor   accounting has slight changes. Therefore, this essay will discuss more on lessee accounting. To begin with, IFRS 16 maintains the definition of a lease in IAS 17 but is different in the concept of control used. It examines whether a contract contains a lease according to the right to control the use of and identified asset for a period of time. In another word, it is required to determine whether the contract is a lease contract or a non-lease contract. For example, Lessee A enters into a 5-year rental contract to lease a warehouse. There are two situations: 1. A can occupy a certain place for 30 cubic meters but the place is determined by the owner. 2. A can occupy a specific and fixed place for 30 cubic meters and nothing would change it during the duration of the contract. In IAS 17, the lessee A will classify it directly as rental expense and do nothing until the end of year. However, according to IFRS 16, lessee A will account for rental expenses in satiation 1, but classify it as lease in situation 2 because an underlying asset can be identified—it is clear for the specific asset and duration.

Also, under IFRS 16, lessees need to split the rental payments in IAS 17 into lease element and non-lease element. Commonly, the rental payment of operating lease in IAS 17 is contained the rental fee and maintenance fee. While in IFRS 16, the rental fee that is a lease element should be classified as lease liability and recognize the maintenance fee which is a non-lease element as expense.

The major change under IFRS 16 is that lessees do not need to classify financial leases and operating leases like what lessees do in IAS 17 at its inception. Instead, a single model of accounting for every lease is adopted. To be more specifically, lessees are required to recognize a right-of-use asset and corresponding liability in its statement of financial position and an asset should be depreciated over the lease term. It is similar to the treatment for finance asset under IAS 17. But IFRS 16 does not apply to the short-term leases and low value lease such as personal computers. It is clearly that IFRS 16 classifies leases into one category and presents the assets and liability correspondently from the table below. Therefore, the off balance sheet rights/obligations under IAS 17 are eliminated. 

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(http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/IFRS_16_effects_analysis.pdf)

It is easier to illustrate it with an example. Lessee A want to lease a warehouse, the annual rental payments are 11000 HKD which includes the 1000 HKD maintenance fee and all payments are paid at the end of year. The discount rate is 8 percent. The lease term is 3 years. Under IAS 17, let us assume the lessee assess the lease as operating lease. The lessee will do nothing at the commencement date, and he or she will book the rental expense of 11000 HKD (rental expense and maintenance expense) in profit or loss. On the contrary, no classification is necessary, as the single model will be applied to all leases. The lease has been identified by assumption, and lessee needs to separate the maintenance element from lease element. Therefore, 10000 HKD is the lease element and 1000HKD is the non-lease element. At the commencement, it is required to recognize right to use in the amount equal to the lease liability. Besides, the liability is calculated at the present value of payment like the way in financial lease in IAS 17. Thus, debit the right-of-use asset in 25771HKD (10000HKD discount at 8%), and credit lease liability in 25771 HKD. Subsequently, recognize the depreciation expense 8590 HKD and interest expense. The prepared table illustrates the example intuitively.