Substance Over lease
The scope of the document
Introduction: Provides brief overview of the article and introduces the topic
The concept of Substance over form: This section explore the concept of substance over form to guide readers how to gain insights.
Why apply a substance to a lease? This section discusses in detail why should you apply substance to a lease agreement. The section also guides how to represent the substance over lease in financial statements.
IASB Accounting Framework Criteria Operating Lease: This section discusses in detail the criteria of IASB to deal with operating lease in an accounting framework.
Financial Lease Indicators: This section will show lease indicators
Examples Clarifying the Lease: Look for examples in this section.
References: this contains references to the content
Introduction
Lease is an arrangement between leasor and leasee, where ownership of use is transferred to the leasee by leasor for an agreed period of time against systematic agreed payments to leasor by leasee. Substance over form is an approach which ensures that the recording of the transactions should not conceal its actual intent. It requires a good judgment from the experts, involved in preparing #financial reports so that they can give a clear picture of their business transactions and events (Grossman & Grossman, 2010). IAS-17 requires accountants to deal with leasing agreements as a commercial transaction rather than just purely legal agreement as recognition of commercial activity and representation in financial statement will ensure businesses effectively honour their liabilities.
The concept of Substance over form
The key criteria for Substance over form is the honest recognition of the processes involved and their credible representation in the financial statements. This requires providing a complete honest picture of the status to allow decision makers and regulators to understand the nature of transaction and responsibilities entailing alongside it. Economic nature of the financial transactions are clearly understood using the concept and appropriate decisions become easier. According to Mintz (2011) economic nature of the financial transaction should be effectively represented in financial statements. IAS-17 recognizes once substance over form is followed and decisions are taken on true economic terms. The standards require effective representation of elements in a financial statement. Because it will diminish the possibility of misrepresentation of the transaction.
Why apply a substance to a lease?
Past practices of business didn’t represented lease in financial statement. Technically, a business under lease agreement maintains an asset for a gain with scheduled payments (Stuebs & Thomas, 2011). The off-balance sheet nature of the transactions hides the involved liabilities hence misrepresentation of the financial performance is unavoidable. There are clear cash inflow and outflows resulting from the use of asset without its representation in financial statement a business cannot be held responsible for honoring the arrangement or at least hiding them for fraudulent representation of company’s financial position.
This requires under Substance over form to consider lease arrangement as an accounting transaction rather than a purely legal one. If not applied investors would not be aware of actual financial position and may take an investment decision based on misrepresented information.
IASB Accounting Framework Criteria
The framework requires the parties involved in preparation of lease to effectively define substance over form before they can actually determine the nature of accounting or financial principles they are going to employee. Since under many circumstances the possibilities to apply an accounting method are various without proper recognition of substance over form. According to Kieso, Weygandt, and Warfield (2010) The framework required lessee to represent asset and liability of the lease at a lower fair value.
We can obtain Present value of the asset via discounting using prevailing interest rate. When the clause to purchase the asset after lease is not there #IASB framework requires lessee to undertake depreciation and perform it over a shorter of lease term considering the life of the asset. For leaser, the transaction is recorded on a balance sheet as a receivable equivalent the amount of net investment. The framework also requires a lessor to represent income of lease via straight line method. Operating Lease and Financial Lease
According to Cotter (2012) there are two types of lease financial and operating lease. Financial lease is classified as the lease in which whole risk and reward with incidental ownership. On the other hand, #operating lease is a type of lease other than financial hence all other types of lease are operating lease.
Lease Indicators
The most prominent indicators are the right to use for full or partial useful life of the asset and if lessee pays for insurance, repairs and maintenance of the asset. The transaction is known as lease when the risk and rewards are technically with the lessee. When taken at asset’s fair minimum lease payment and the asset is classified as specialised asset are qualified indicators of a financial lease. The activity is treated as lease when the ownership is transferred back when lease arrangement terminates.
According to Mintz (2011) IFRIC also considers some transactions as not clearly lease and explains them as embedded lease arrangements, hence fall under operating lease arrangements, the regulatory authority also demands that these lease types should also be managed under IAS-17 concepts. In contemporary business environment outsourcing has increased comprising of take or pay contracts. This is a lease agreement where even if contractor is accepting on the delivery of the product or services.
According to Barth and Schipper (2008) manufacturers retain the role of decision making while regularly outsourcing many activities, this includes using supplier equipment on many occasions. The decision making is primarily concerned with how to effectively use the equipment. Hence, when manufactures use supplier equipment, it should be managed under the lease principles.
More effectively the activity is recorded as financial activity and represented in financial statements. A business is planning to lease a plaza, in this case it is clear and evident from both perspectives it a lease arrangement (Stuebs & Thomas, 2011). In other cases, a closer evaluation is required as in substance, because the arrangement may transfer the right to use without explicitly stating it.
IAS-17 principles can effectively ensure lease is managed by recognizing its form and nature. Defining the lease as financial or operating and determining the right standards of financial and accounting principles to govern those transactions. According to Stuebs and Thomas (2011) there are many different method that lead to different outcomes hence defining the nature is critical to the process.
Examples Clarifying the Lease
Considering an example of a manufacturer in this case a purchaser, who undertakes a contract the supplier to provide a minimum quantity of output for a period of three years. In this case the supplier customizes its facility for purchaser and buyer is overseeing the whole process and is in control of the key processes. Moreover, buyer is paying a fixed capacity charge in addition to variable charge according to the actual production. These arrangements also fall under IAS-17 and terms as lease which is represented as so in the financial statements (Grossman & Grossman, 2010).
Similarly, if a company sells its equipment’s to the bank because of having less cash and then leases the same machinery from the bank. The transaction is recognised as “sale and lease back”. Even though the legal possession has been shifted to the bank, the fundamental economic substance or the company remain the same. Under the of substance-over-form principle, the sale and consequent leaseback is measured as one transaction (Barth & Schipper, 2008). Another example is if two companies exchange their inventories, this action is not considered as sale because the object is a mere in-kind exchange. Regardless of the possible procedure of legal enforceable agreements for two sales and deliveries.
Similarly, if a company decides to withdraw an inventory for internal use; It is recorded in a separate account from the account of sales. Therefore, the principle sustains the sales account as reflecting the real sales in substance i.e. objects supplied to the outside for payment and not the actions taken for one’s own convenience.
In a recent report published by Standard Chartered claims that they lease the equipment’s (gold, platinum and silver) following the IAS 17 standards as according to them major number of equipment being leased are not financial transactions, but merely rental agreements (Stuebs Jr & Thomas, 2009). IAS 17 is a better indicator of a lease contract and gives an authority to use an equipment without taking asset risk.
References
Barth, M. E., & Schipper, K. (2008). Financial reporting transparency. Journal of Accounting, Auditing & Finance, 23(2), 173-190 %@ 0148-0558X.
Cotter, D. (2012). Advanced financial reporting: A complete guide to IFRS: Financial Times/Prentice Hall.
Grossman, A. M., & Grossman, S. D. (2010). Capitalizing lease payments. The CPA Journal, 80(5), 6 %@ 0732-8435.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate accounting: IFRS edition (Vol. 2 %@ 0470616318): John Wiley & Sons.
Mintz, S. M. (2011). Ethics, professional judgment, and principles-based decision making under IFRS. The CPA Journal, 81(1), 68 %@ 0732-8435.
Stuebs Jr, M. T., & Thomas, C. W. (2009). Improved judgment in financial accounting: A principled approach. The CPA Journal, 79(1), 32 %@ 0732-8435.
Stuebs, M. T., & Thomas, C. W. (2011). Principles-based accounting: The case for principled judgment Research on professional responsibility and ethics in accounting (pp. 47-73 %@ 1574-0765): Emerald Group Publishing Limited.