Answer

The AASB (Australian Accounting Standard Board) issued a revised accounting policy AASB 16, Accounting for Leases to replace AASB 117; the effective date for the new AASB 16 was 1^st January, 2019. This change is expected to have a great impact on most Australian entities with huge amounts of Leases.  Implementation of AASB 16 was aimed at eliminating off-balance sheet financing. AASB 16 eliminates discrepancies by disclosing the Leases. In this essay, we will evaluate the deficiencies of AASB 117, the changes incorporated in the new AASB 16  and if the change were necessary,  and the overall  impact on firms with significant levels of lease financing (Wong 2015). An ASX Limited chosen company will be analyzed to determine disclosures made on accounting for leases, and its transitional provision and effects of changing from AASB 117 to AASB 16. This is expected to improve comparison between companies that take on lease contracts and companies that purchase assets through loan financing. This new accounting policy is also expected to impact decisions by firms on whether to lease or purchase assets in their balance sheet.  However, with the complexities and rigorous nature introduced by AASB, there is need for further simplification, as the shareholders may still not be able to fully understand the financial statements.

Introduction

There may be very immaterial change in the definition of leases in both AASB 16 and AASB 117, however a few differences exist. AASB 16 provides guidance on how to classify a lease contract, depending on a few factors that will be discussed in this paper. Under AASB 16, an asset has to be in place and therefore recognize a liability and an asset; also payments needed to be classified as either lease contract or  service contract so as to account for services under expense in the income statement (AASB, 2015). Under old IAS 17, there was no differentiation in the leases reported; both were included as rental payments in the expense category of in the income statement.

            Discussion

In AASB 117, lease contracts were not reported on by the lessee on their balance sheet. Information about leases the company controlled and used was only contained in notes to financial statements. Non-disclosure on statement of financial position with regards to lease contracts controlled by or used by the firms was one of the biggest drawbacks of AASB 117. A lease in this AASB is classified as finance, only if the substantiality, that all the risks as well as rewards incident which is associated with ownership from the lessor (Brumm & Liu, 2019). If this is not met, then the lease will be classified as an operating leasee. It is worth to note that the classification, depends on the contractual agreement between the lessor and leasee.  Investors and analysts who heavily relied on information to determine the company’s assets base and financial leverage without considering notes to financial statements had an inaccurate estimation of the performance of the firm and its financial position (Jourbet & Parle 2017).

When the lease asset is transferred to the leasee, then the lease contract come to an end. There is no option provided to the lessor, selling the asset at a price which is lower than the fair value in the market, at the date at which the contract becomes enforceable. Upon inception of a lease contract, AASB 117, assumes that it will be automatically enforceable or exercisable. This must be ascertained at the inception stage of the lease contract (Wong, Wong & Jeter,2016). Once the contract has been signed, the leasee cannot change the price quoted whatsoever. All other factors which show that the risks, as well as the benefits of ownership have been transferred from the lessor and the stated lessee.

According to the guidelines given by AASB 117, finance which has been outsourced through leasing, is recorder both as an asset, and a liability. This record must be done at the lower value of the fair value of the asset, as well as the present value weighed against the required minimum lease payments. The finance should then be apportioned between the interest expenses out of the lease contract, and the redemption of the outstanding lease liability. The lease must be amortized as per the deprecation policies of other assets owned. An operating lease can only be recognized as an expense over the lease duration or term.  This is done on a straight line depreciation basis, unless another option such as systematic basis is established to be more applicable.

Implementation of AASB 16 was necessary to improve the quality of financial reports of companies with large leases contracts; it also provided faithful representation of the degree of leverage in the firm and the capital employed by the firm. Changes incorporated by AASB 16 were such as;

• Recognition is to be done on the commencement of the contract.

• More expenses in the first year due to huge interests on commencement, and decreased total expenses at end of lease due to amortization of the lease liability.
• Under AASB 16, more assets and liability obligations were shown which in turn reduced adjustments made to the financial statements by investors and analysts.
• In the cash flow statement under AASB 16, total principal portion paid is to be included whereas the interest included in either financing or operating activities.

For companies with huge lease financing, change to the new AASB will lead to a higher asset base in comparison to the asset base reported by AASB 117 due to recognition of the right of use of asset that was previously not recognized in AASB 117. This will in turn have an impact on the asset turnover ratio. The gearing ratio of the firm is also bound to be higher due to higher financial liability as AASB 16 recognizes all the lease liabilities previously. Under AASB 16, the operating profits of the firm are likely to be higher compared to the operating profit under AASB 177 as interest expense is excluded from calculation of operating expense while under AASB 117 it was included as operating lease expense.    

Under AASB 117, companies had a tendency of classifying their lease contract under operating lease rather than finance lease as under finance leases, lease contracts were treated as loan finance and therefore appeared in the balance sheet, which would potentially increase leverage ratios and reduce the asset turnover ratios. Classifying the lease contracts under operating leases, the lease payments were recognized as rental payments in the income statement which increased the operating expenses reported thereby reducing the firm’s tax liability (AASB 2015). Positive accounting theories tries to predict and explain the accounting policies managers of a firm are likely to choose and how their reactions to any new accounting standards. Under Positive accounting, managers try have a high need of efficiency through minimization of contract costs . This therefore means they will tend to use accounting policies that enable them minimize their costs which may serve their own selfish interest and not necessarily for the good of the firm.  The new AASB 16 may also have an impact in the remuneration of the managers. This would explain why firms under AASB 117 classified their lease contracts as operating leases

With this change, companies will now have to include the costs incurred in asset or assets during lease contract, as well as benefits realized in the statement of financial position at the end of the period. AASB enhance the level if accuracy of presentation in the statement of financial position.  This is due to the fact that it provides a more useful information used in financial reporting for shareholders, as well as other potential investors, but is done in a downside manner. Other than this, the rent expense, will not now be expensed in advance, hence causing at increase in the Earnings Before Interest and Tax (EBIT). These among others are the expected changes in the financial statements.

This newly implemented accounting for leases policy is deemed to improve comparison between companies purchase assets through loan financing and companies that lease assets. By disclosing the leases in the balance sheet, it will be classified both under the asset and liability category, the lease contracts will be classified as loans which is has same treatment as an asset financed by a loan. Classification under asset will be the same as the asset financed by a loan. Under AASB 117, estimates made by investors and analysts regarding lease liabilities were in most cases higher than they would have been with accurate figures. With AASB 16mandatory disclosure by companies will result in more accurate figures which will enhance comparability between companies (Parle 2017).

With this new standard (AASB 16), comparability between companies which borrow and companies which lease the assets will be made easy. This is due to the fact that, the liabilities which accrue on the assets, as well as the benefits during the lease contract period thereof, will be recorded separately. Owing to the fact that assets will be recorded at a price which is lower than the market value, it will be much easier to compare the leasing companies with the borrowing companies, in terms of comparing the accrued interest realized. Easy comparability will benefit the shareholders, who have had a difficulty in understanding fully the lease finance. Besides, it will make it easy for the potential investors in the leasing company to be able to fully comprehend the leverage level of the leasing company.

In the former accounting standard (AASB 117), mots lease contracts were classified as operating lease. The reason as to why this was common was due to the fact that, all the amount of the minimum lease payments at the end of the financial or trading year, became non-cancellable. Leases of between two to five years, had their rents recognized as a contingent rent expense. Most leasing contracts were just having a general description, with no proper classification of the various items of the lease contract (Joubert, Garvie & Parle, 2017).  All the required minimum lease payments at the end of trading period, under non-cancellable operating leases were put together, for the periods between two to five years. The contingent rent was also recognized as income by the lessor.

After implementation of the AASB 16, companies may prefer to buy assets more compared to leasing for the following reasons;

• Lease payments increase the liabilities reported and this will result in a higher leverage ratio for the firm as opposed to buying the asset in cash.
• Interest payments are excluded from the operating expenses this increases the operating profit which results in higher tax liabilities.
• Purchasing gives the company immediate ownership which may not always be the case with lease contracts.

Domino’s Pizza Accounting for Leases Disclosure

Domino’s Pizza Limited is one of the companies listed under the 200 ASX companies; its core business is pizza delivery with franchises all over the world.  A review of the note to its consolidated financial statements reveals that the AASB 16 accounting standard is not yet adopted.  It has considered new accounting policies issued by AASB and concluded that the policies may impact its consolidated financial statements and the company is yet to fully assess the accounting policies before implementation (Domino’s, 2018). The policy requires that the lessee recognizes its assets and liabilities on its statement of financial position of leases with duration of more than 12months. Although it is permitted to adopt the policies earlier, Domino’s will adopt the AASB 16 before the first day of 2019(Annual Report, 2018).

            The period for which the financial statements have been prepared, is before commencement of the new accounting standard. However, auditing takes place at the time when AASB is in place, hence making the financial statements to have some aspects of the standard. The effective date for AASB 16, is 1^st January 2019. ). The current financial statements therefore, does not have any reflection of the standard, despite the fact that the auditor has acknowledged that it will be implemented in the next auditing This means that most companies will be able to adopt this financial statements when preparing the financial statements for the period ended December 2019. The full compliance will be reflected in either the final books of June 2020 or the interim books. Domino’s just like any other listed and limited company, it will be able to be in full compliant by then. In the current statement of financial position, the cost incurred while using the asset has not been recorded in the statements of financial position. Only the cost has been recorded, at and at value which is higher than the fair value in the market. This will change, as in the next trading year, all the financial benefits as well as assets which will have been realized during the trading year ending December 2019,  2019/2020 trading year, will have to be recorded in the statement of financial position.

            The current financial statements have not created a remarkable distinction between the financial for the lessor and that of the lessee. In the new financial statement, there will be a noticeable difference between the finance from the lessee and that of the lessor. This will be realized owing to the fact that, all the benefits and expenses will be recorded separately. Besides, the assets leased will be recorded at a cost which is less than the fair value stated on the market.  In the current financial statement, there is minimal analysis of the current financial statement. There is no disclosure whatsoever on the telecom operators (Domino’s 2018). This will be required in the financial statement presented in the year 2020, as it will be the basis of indicating a possible average in the Earnings before Interest and Tax (EBIT). The financial statement does not show the margin on the EBIDA, as will be required by the AASB 16.

The Company will put in place measures to maintain existing lease contracts, and further anticipate the effect that adopting the AASB 16 will have on its income statement and cash flows statement. This is expected not have a huge impact on the financial reports. Domino’s is finalizing the policy adoption , it also expects that the adoption will lead to recognizing  the assets and liabilities of the lease commitments under operating leases of estimated $230 million on adoption date.  With regards to accounting for finance leases, the company will maintain consistency with the current capital leases accounting policy (Annual Report, 2018).

Conclusion

AASB implementation may not be a welcomed move by most companies. This is due to its possibility of increasing the leverage ratio of the firm with significant off balance assets. This will turn bring friction between the company and the financers. The operating lease will be eliminated under rental payments in the expenses. On the positive side, Investors analysts will have sufficient information for decision making purposes, unlike the estimations that they would carry out with AASB 117, AASB 16 offers accurate figures that are a true reflection of the affairs of the company. Companies will take different approaches in adoption.  The potential investors, as well as the current shareholders of limited companies stands to benefit most. In the past, reporting of finance which has been sourced through lease has not been very clear. This has made some investors to make w wrong decision, as the gearing level of a company is a key ingredient in making an investment decision.

With separation between the lessor’s and the lessee’s finance, the shareholders will be able to know clearly, the benefits accrued by the leased asset. AASB 117 had a lot of complexities, which made most shareholders not to fully understand the financial statements fully. Recording of neither the depreciation cost, nor the benefits accrued out of the lased property, made the shareholders not to realize the total investment benefit, save the normal dividend declared. It is however, worth to note that a number of areas as still bleak to the shareholders, and AASB is rigorous, that a layman may not be able to fully understand and interpret it. It calls for the professionals to find a means of further simplifying the standard, so as to favor all the users of financial statements.