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This report assesses the current lease financing standard and justify whether it is necessary to reform the accounting treatment for leases. It also discusses the International Accounting Standard 17 (IAS 17) and G4+1 proposal, their main objectives and shortfalls. Evidence indicates that the existing standard consists of several deficiencies; these arise due to the inconsistent methods used. The G4+1 approach suggest solutions to these problems. In spite of this, there are still some issues that need to be resolved in order to ensure that companies will fully comply with this new approach. The recommendations advise to adopt the new approach in order to reduce the insufficiencies with the current standard.
Before IAS 17 there were two main reasons to why leasing accounting was attractive: the tax advantage where lessors were able to claim first year allowance which reduces the company's tax bill. The second advantage was leasing is to enable companies to spread payments over the leasing period.
Nonetheless, there was no uniformity in the treatment of the leasing transaction disclosures in the growing lease industry and off balance sheet financing. So IAS 17 was introduced to prevent manipulation of lease accounting and to present a true and fair value. Yet significant deficits in this standard induced the G4+1 proposal.
The Current Standard: IAS 17
IAS 17 defines a lease as "an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time." IAS 17 categorises leases into two types: Finance leases and Operating leases. It ensures that the companies correctly classified them.
Finance leases allow lessors to transfer all risks and rewards of the asset to the lessee at the end of the leasing period. This means that the lessee should capitalise the lease by recognising the asset and the future payment as a liability on the balance sheet. Capitalisation prevents companies from using off balance sheet financing. Whereas, operating leases only account for expenses of the rental on the income statement, (Goodacre, 2003). This standard allowed flexibility, management were capable of classifying the lease.
The Controversial Issues of IAS 17
Although IAS 17 was a feasible solution to avoid malpractice of accounting treatments, there are disagreements about the "substance over form" approach in comparison to the traditional method, which takes stricter approach to legal ownership. It provided broad guidelines that can be applied in numerous ways and disclosures justify why the leases have been classified in this way. IAS 17 (revised 1997) created a useful flow chart which allows easy classifications of the leases, which in doing so created a "comfort zone" for firms, as liabilities of operating leases are not recognised on the balance sheet and lowers the gearing ratio. Operating leases are extremely attractive so managers try to avoid capitalisation of finance leases by restructuring them as operating leases. (Lipe, 2001)
McGregor, (1996) suggested there were three deficiencies with the current standard. Firstly, the absence material assets and liabilities arising from "off-balance sheet" operating lease contracts. Secondly, similar transactions were not treated the same because they are classified differently. Thirdly, the "all or nothing" approach to the capitalisation of leased assets does not reflect the complex transactions.
The New Approach
Accounting Standard Setters from the UK, Australia, Canada, New Zealand, USA and International Accounting Standard Committee (IASC, an extension of G4+1 group) issued a special report. Accounting for Lease: A New Approach. McGregor, 1996 stated that, "all finance leases and most, if not all, operating leases qualify for recognition as assets and liabilities." This paper implies that classifying the leases as operating or finance is "unsatisfactory". In addition it suggests that there would be improvements in comparability of financial statements if all leases were classified the same. The operating leases should be treated as finance leases and that all leased assets and liabilities should be treated the same way to avoid manipulation. Imhoff and Thomas (1988) propose that if there are loopholes present in accounting standards, management will exploit it. Firms would want to reduce the length of the contract if it determines the significance of the liability, (Goodacre, 2003).
Lessees should recognise the fair value of assets and liabilities contained in the lease contract so their balance sheets should reflect additional liabilities if the new approach is adopted. It also suggests that balance sheet recognition of operating leases would provide useful for decision making purposes, (Ryan et al, 2001). A further position paper issued in 1999 suggested that operating leases should be included in the balance sheet. This would bring to the surface the assets and liabilities reported at a fair value of rights and obligations conveyed in the lease.
The Drawbacks of G4+1
Majority of preparers of accounts disagree with the G4+1 approach as they are already familiar with IAS 17. Thus, it will be difficult to successfully introduce a new approach. They also believe that it is unreasonable if they have to bear the costs and users obtain the benefits from the improved information. However, they seem to ignore the potential long term benefits (Beattie et al, 2006). Providing a new standard for the lease accounting treatment will lead to undesirable economic consequences. Goodacre, 2003 suggested that classification of leases affects lessee's performance ratios, so companies may be reluctant to change their operating leases all into finance leases.
The Accounting Standard Board (ASB) realised that the main principles of the G4+1 paper becoming common and is a growing practise for analysts recasting financial statements by capitalising operating leases. Hence, it seems sensible to apply a modified version of a finance leasing model as one approach for all leases.
There are many criticisms of G4+1, some fear that IASC's "existence and dominance" as a standard setter could be endangered by G4. It is thought that restructuring the proposal to meet G4+1's concerns will allow G4+1 and the IASC to work together. However, if the approach was executed in its present form it may develop two competing "internationally recognised standards": the G4 and IASC, (Street and Shaughnessy, 1998)
To conclude, IAS 17 was implemented to prevent manipulation in leasing treatment as leasing became a popular source of finance. Yet there were insufficiencies with this standard, such as companies categorising leases as operating leases instead of finance leases. There are also debates about the "substance over form" approach. This standard was unable to get rid of the off balance sheet financing nature of some the leases. Thus, G4+1 tried to implement a new approach. This approach was not fully supported by many, especially the preparers but on the whole, it will allow preparers and users to justifiably report leasing. This new approach will most likely be reflected in a revised or new accounting standard in the future.
Operating leases and finance leases should be treated the same; both should be recognised as assets and liabilities in the balance sheet.
It is important to take into consideration what the preparers and users think of the reform and whether it is beneficial.
G4+1 could initially serve as a benchmark to companies
Footnote disclosures on capitalisation of leases should be included on financial reports
Adopting a new approach will initially create a shock, however preparers and users of accounts will eventually benefit from the improved information.