Question

Alan Tan is the CEO for an airline company. The company has a large proportion of its aircraft leased from manufacturers under lease agreements that can be cancelled at any time with minimal penalties. At the end of the period starting on 1 January 2019, looking at the statement of financial position prepared by the company accountant, Joyce Maine, Alan noticed a large increase in the total assets and liabilities. Not being aware of any major restructuring activities or investments during the period but having heard about a change in the accounting rules governing leases, Alan asks Joyce to prepare a report describing how the changes in those accounting rules affect the company.

Required

Joyce approaches you, a junior accountant, to summarise the changes in the treatment of some leases that caused the large increase in the total assets and liabilities. Provide a short description of those changes to Joyce.

Answer 1

The accounting standard for leases issued by standard-setting bodies in the 1980s and updated throughout the 1990s and early 2000s (i.e. AASB 117/IAS 17Leases) did not fully address this concern. Under this standard, some leased assets and their associated liabilities were required to be placed in statements of financial position (i.e. those arising from any lease classified as a ‘finance lease’), while other leased assets and associated liabilities were still allowed to be off-balance sheet (i.e. those arising from ‘operating leases’). For operating leases, the lessee was only required to recognize the annual payments under the lease expenses every year (normal accrual rules would have been applied for payments in advance that would have been recognized as prepayments).

The Financial Accounting Standards Board (FASB) introduced a new accounting standard (ASU 2016-02) that requires companies to recognize operating lease assets and liabilities on the balance sheet. The impact of this change is almost entirely around lessee accounting (companies that pay leases)

Prior to this new accounting standard, GAAP required the assets and liabilities associated with capital leases to be on a company’s balance sheet. Typically, these leases are in relation to property, plant and equipment (PP&E) i.e aircraft in this case, so the capital lease assets were recorded in PP&E while the lease liabilities were recorded in debt or other liabilities.

On the other hand, operating leases, both the assets and liabilities, were not reported on the balance sheet, despite the fact that entities were using the assets and contractually obligated to pay the lease. Also prior to this change, capital leases required separate depreciation and interest expenses, whereas operating leases required a lump-sum lease payment or rental expense.

The single largest change in FASB’s ASU 2016-02 is the requirement of operating leases to have the associated asset and liability recorded on the balance sheet at the present value of future lease payments. These large assets and liabilities, once hidden in the notes, will now be placed directly on the balance sheet,

The new standard still requires just one lease/rental expense reported. However, because assets are now recognized, impairments will also be recognized on the income statement, outside of this single lease cost.

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