Introduction
A lease is a contract enforceable by law which defines an agreement between a lessor (owner of property) and lessee (renter of a certain property). It defines things like the duration of the lease agreement, the amount of rent, and any other conditions defining the lease agreement. When a business has acquired properties through a lease agreement, it must report in its financial statement as prescribed in ISA 17. Discussions are underway by the International Accounting Standards Board (IASB) to change the system (ISA 17) which is expected to take full effect on June 2011 (Kuczborski 2010). This paper looks into the decision to change the new system; it will look into advantages and disadvantages analyse how it will affect financial accounts of Morrisons Limited and finally as a conclusion give the writer’s opinion.
Changes in ISA 17
Financial Accounting Standards Board’s (FASB’s) has defined how leases are to be accounted for since 1976; however there have been some issues brought about by the accounting methods; these issues are,
- The mode recognises more than one accounting methods (it does not specifically have a defined way of accounting for leases).
- The flexibility of methods adopted can allow manipulation of financial accounting data.
- The method recognise contractually liability and at the same time accounts for asset acquisition.
- The disclosure and the assets are not reflected in the balance sheet and thus offers an off balance sheet liability (IFRS 2010).
The international accounting bodies recognized these needs and in March 2009, FASB and IASB, represented a proposal which recommended for changes in the accounting branch. The major proposal they represented was that when accounting for leases, they should be included in balance sheet for the lessee and the lessor (Kamal, Habif & Wynne 2010).
Advantages of the Proposed Changes
Will assist in making better decision
The change will result in better financial statements which can assist people who make their decisions based on financial statement have better information. Their involvement in the balance sheet as liabilities (rental charges) and the asset according to its nature removes the off balance sheet liability that had existed for a long period of time. This transparency is good for sound decision making.
Will assist in upholding integrity in management
When the system is fully in place, it will control manipulation by management accountants to fit their accounting agendas. The way of accounting will be well defined and structured to seal loopholes which have been used for manipulation (Nobes & Parker 2008). This invention will offer the accounting method required. This will be so because the new changes will define only one way of accounting for leases. Financial statements are management tools, which assist in making decisions.
Will assist in financial comparability
For better accounting and comparability of financial accounting and better decision making, there is need to have a similar accounting method. When a uniform standard has been developed then comparison in similar industries will be easier. This is because there is a similar platform that companies are using. Making managerial decisions will thus be from an informed decision. There are times that a business may require some expert assistance in a certain area; the experts (especially financial advisers), use published accounts to advise the company accordingly. If the accounts are prepared in a way that they give the true status of the company, the quality of the advice they are likely to receive will be enhanced. This leads to a general good performance of the company (Christy 2010).
Removes wrong impression previously given by the balance sheet
The system realizes that there are some elements in the balance sheet that can give the wrong impression to those who depend on it for their decision. One of these items is intangible assets. Consistency is another area of great interest to the users especially lenders and creditors. The way to measure the level of consistency, which in turn shows the level of efficiency of the management, is the use of accounts that do not have a lot of deferred payments. This is because they will show the trend that the business has followed all along (Mirza & Orrell 2008).
Disadvantages of the Proposed Changes
It’s an imaginary disclosure
The method recognises that leased assets should be shown in the balance sheet. This is not true transaction since the definition of assets according to International financial standards does not include leases. This is like a contradiction of accounting frameworks.
Gives an impression that a company is highly geared
Secondly, the move requires that rental fees should be recognized as liabilities; this will show a company as highly geared. The cost of lease is expensive than other ways of acquiring capital and thus when included in accounting statements, it can show a reflection of a bad credit policy which is not the case always.
Expensive in maintenance and evaluation
Managing the leases will be on real time basis where a company will require up-to-date information on the estimate they have to make on the lease. This is an added burden to a company; both the lessee and lessor. The presence of a lease in a balance sheet will make the debt portfolio to grow and thus when a company is being evaluated by banks and other capital lenders they will see it as if it has a high financial obligation and thus avoid business with it; this is to the disadvantage of the company (Barry and Jermakowicz 2010).
Changes in a Company
Company brief background
Morrison’s Limited is the fourth largest United Kingdom based fresh-produce supplier with 403 branches. It is in the business of selling fresh produce and green grocery with approximately 124,000 employees. According to the company’s website, each week it serves a total of 9million customers. The company acquires 10,000 to 40,000 ft stores through leases. The company’s profit before tax was 858million. The profit is a divided cover of 2.5.
The company’s leases; land& building and plant and machinery for 2010 which are expiring are shown as follows;
The above information was given in notes to financial statements; it has not been reflected in the balance sheet (Morison Limited official website 2010).
The expected change in ISA 17 is expected to affect the company’s financial ratios;
Gearing Ratio
If the company was using the new method, then long term debts would have been higher. On the other hand, the percentage financed by long term liabilities would have been higher. This is a reflection of a business that was more highly geared than the case is. The result is a misguidance to the investors.
Deferred Tax
If leases had been accounted for in accordance to the proposed way then there would have been an increase in the fixed assets. In the company’s balance sheet the element of deferred taxation will occur. This will be interpolated as a financial obligation that the company aims to undertake in future.
Current Ratio
Since short term leases will be considered as short term liabilities, it will show a lower current ratio (Elliott & Elliot 2009).
Personal Opinion
The move to change accounting for leases is a move that is aimed at ensuring that financial statement report more precise information to the users. In the case of companies using leased assets they will have a “right to use” asset in their balance sheet. This will assist users of account to know the precise sources of capital of a company and can calculate the financial strength of the company more precisely. The proposal is clear that short term leases will be shown as short term liabilities and long term as large liabilities. This will assist further in understanding a business. In my opinion when an investor is making a decision to invest in a certain business, he needs to know the real financial standing of the company.
When leases are included in a balance sheet this objective is fulfilled. Lease has been used as a tool to manipulate financial statements since it was not reported with the financial statements. This was giving a loophole to management to have some “hidden” liabilities which is not a healthy move. Some companies have regarded the use of leases as a financing move and thus in cases where they are not reported in the balance sheet comparing such statement with those which have financing in their account is not right.
The only controversy that I feel the move will bring is that the ways leases are reported according to the proposal are treated as if they are assets acquired by a business. They are valued and given higher value or a lower value, however considering their nature, the contract of lease does not recognise any appreciation or depreciation of a lease. Secondly, the move will place a burden to management to monitor a lease from start to the end; they should know when the lease is changing, when the lease can be renewed, and the estimate value of the lease among other ongoing factors of the lease. This is an extra cost especially in today’s hard economic times (ASB proposes changes to accounting for leases 2000).
Conclusion
The new recommended change in accounting for leases is going to offer higher reliability and integrity to financial accounts. It will disclose some information which was earlier accounted for as off-balance sheet liabilities. When the new system takes effect, all these will be reflected in the balance sheet. This will avoid any manipulation of accounts by company’s management and at the same time assist investors to better analyse a company financial standing.
The proposed method will offer a platform and guidance to companies on a similar accounting method they have to adopt, this will create a better comparability platform of companies in the same industry. The problem is that the system will bring a burden to management to monitor a lease from start to the end; they should know when the lease is changing, when the lease can be renewed, the estimate value of the lease among other ongoing factors of the lease. However, the benefits of the new system far outweigh its shortcomings.
References
ASB proposes changes to accounting for leases. 2000. Management Accounting [British] 78.2 : 10. Academic One File. Web.
Barry J. and Jermakowicz, K. 2010. Wiley IFRS 2010: Interpretation and Application of International Financial Reporting Standards. New York, John Wiley and Sons.
Christy K. 2010. Major Changes in Accounting for Leases. Web.
Elliott, B. & Elliot J. 2009. Financial Accounting & Reporting, 13th edition. New York, Prentice Hall IFRS. IASB 2010. IASB Meeting Summaries and Observer Notes. Web.
Kamal P., Habif, A. & Wynne, L. 2010. Accounting and Consulting. How changes in accounting for leases will affect your company. Web.
Kuczborski, M. 2010. Major Lease Accounting Changes on the Way. Web.
Mirza, H. and Orrell W. 2008. IFRS Workbook and Guide. New York: John Wiley & Sons.
Morrisons Limited official website. 2010. Financial Report. Web.
Nobes, C. and Parker, P. 2008. Comparative International Accounting. New York: Financial Times Press.