BAP62 Importance of AASB 16 Leases in Wesfarmers: Issues in Financial Accounting Assessment Answer
Issues in Financial Accounting
A lease is an agreement under which a lessor permits the lessee to manage the utilization of an identified plant, equipment and property. It is executed for a specific period of time along with an exchange for an amount. There are various designations of a lease which differ depending upon whether the entity is a lessor or a lessee. A lease can be designated as an operating or finance lease. It is the responsibility of the lessee to clarify whether a lease should be a financial lease. In this context, the International Accounting Standards Board issued IFRS16 Leases in the month of January 2016. It has introduced a new model which require the lessees to identify all the leases on the balance sheet of the company, except the leases pertaining to low valued assets and short term leases. These changes are also introduced by the Australian Accounting Standard Board in the month of February 2016. They are to be implemented for a period beginning on or after 1st January 2019.
AASB 16 introduces an accounting model of a single lease. It requires the lessee to identify assets and liabilities for all the leases with a time period of more than 12 months. The assets of low value and shorter term lease have been excluded by this accounting standard. This report analyses AASB 16 Leases in the context of Wesfarmers, a company dealing in retail, fertilizers, chemicals, industrial, coal mining and safety products. It is amongst the top 100 ASX listed companies. It also includes a literature review with application and analysis of recognition, measurement and disclosure of lease pertinent to the company. The report also recommends and critically reflects the various aspects of AASB 16.t requires the lessee to analyze the right-of-use asset which represents the right to utilize the underlying asset along with a lease liability which represents the obligation of the lessee to make payments related to it (Deloitte, 2016).
So, this report illustrates the importance of AASB 16 Leases in the context of Wesfarmers, a retail business company dealing in fertilizers, chemicals, industrial, coal mining and safety products. It is amongst the top 100 ASX listed companies (Wesfarmers, n.d.1).It also comprises of a literature review which applies and analysis the recognition, measurement and disclosure aspects of a lease on the company. Lastly, it shall provide certain recommendations along with critically reflecting the various aspects of AASB 16.
As per the opinion of Joubert, Garvie and Parle ( 2017), there are many purposes of issuing this standard. One of them is that lease has become an important medium to obtain finances and to gain access to the assets. It also helps in reducing the exposure to the risk of owning the assets by the entities. The lessee evaluates the right-to-use assets in a similar way as he measures other non-financial assets like machinery, plant and equipment. He also measures the depreciation on his right-to-use asset along with the interest on the lease liability.
The lessee also categorizes the cash payment of the liability arising from lease into principle and interest portion. He also represents them in the statement of cash flow by implementing AASB107 Statement of Cash Flows (Deloitte, 2019). It is believed that in the current scenario, leasing has gained importance as the users of financial statements want to have a complete picture of the leasing activities of the entity. The earlier model of lease required lessor and lessee to categorize their leases as operating or financial leases (Xu, Davidson and Cheong, 2017). With the changes in time, companies are using the two type of lease such as capital lease and operating lease to acquire assets and plants in the books of account of company.
They were required to account for these leases separately. As a result, it was criticized because it failed to meet the necessities of users of financial statements. It did not represent the transactions of a lease in a fair manner (Dakis, 2016).
Particularly, under the previous model, the lessees failed to recognize the assets and liabilities arising due to operating assets. So, the International Accounting Standard Board and Financial Accounting Standard Board jointly developed a new approach to the accounting of lease which required the lessee to identify the assets and liabilities arising due to operating leases.
In my opinion, it would result in a fair representation of the assets and liabilities of the lessee with enhanced disclosures which shall provide transparency of the financial leverage and capital employed of the lessee.
In Australia, AASB 16 Leases is applicable to the annual reporting periods starting on or after 1st January 2019. As per AASB 16, the assets and liabilities which arise from the lease are measured on the basis of their present value. This measurement comprises of lease payments which are non-cancellable. They also cover inflation-linked payments along with those which are to be made in optional periods, provided that the lessee will certainly exercise the option for the lease extension. In other cases, he shall not exercise the option which will result in lease termination (Holland, 2016). In terms of recognition, measurement and disclosure under the newly introduced standard, it should be noted that the liabilities related to lease and the right-to-use assets should be recognized for leases where the company is a lessee. Companies should also focus on the specific transition disclosure which is required to be disclosed in the annual statements as perAASB16. It may also disclose that it has grandfathered or continue to apply its previous assessment pertaining to if the arrangement was a lease as per the earlier standard (Petschler, 2018). This has shown that company has more capital lease in its books of account and followed capital lease rules and regulations.
Application of AASB 16 on Wesfarmers
Although AASB 16 was not effective until the time period commencing on or after 1st January 2019 but many companies have started implementing the leasing provisions. Coles, a subsidiary of Wesfarmers has adopted appropriate management practices and leasing structures to safeguard the tenure of its current stores dealing in food and liquor. It has also disclosed that in the mining sector, the leases are to be granted over MDL 162 area which is adjacent to Curragh. The approvals from Common Wealth are being awaited in this regard (Wesfarmers, n.d.2).
In 2016, operating lease payments were recognized as an expense in the income statements. They were measured on a straight line basis over their lease term. The operating lease incentives were recognized as a liability when they would be received. They shall be shown in the income statement on the basis of the straight-line method over their total lease term. In 2016, the minimum lease payments amounted to $2,330 Million as compared to $2,068 Million in 2015. In 2017, the minimum lease expenses amounted to $2,339 Million and $2, 2281 in the year 2018 (Wesfarmers, n.d.3). All the operating lease expense were recognized as expenses in the income statements. They were calculated on a straight line basis over the term of the lease (Wesfarmers, n.d.4).
So, it has been analyzed that there would be significant effects on all the entities implementing AASB 16. For lessees, the balance sheet would be expanded through the recognition of the newly introduced assets and liabilities.
In the income statements, the profile of lease expenses would be front-loaded particularly for the individual lease. It would be presented as depreciation and interest instead of as an operating expense. In the context of Wesfarmers, the operating expenditures relating to lease would be described as depreciation and interest with the exception of variable rentals which would be expensed as incurred. It implies that various key performance indicators of Wesfarmers would be impacted. In the context of Earnings before interest, tax, depreciation and amortization (EBITDA), the statement of cash flows would be affected. The payments would be split between repayments of interest as well as principal ( KPMG, 2019).
Thus, Wesfarmers is being advised to consider these effects in the areas pertaining to Key Performance Indicators (KPI), contingent considerations in combinations relating to business, bonus target and executive remuneration schemes and taxation as well. The users of financial statements of the company have to consider the aspects related to debt covenants and the ability of the company to pay dividends as per the newly introduced standard. The company is also required to fulfill the regulatory capital requirements. In order to avoid unfavorable situations in the future, the company has to renegotiate the contractual arrangements along with those which are now in transition to AASB16. The effects of the newly introduced standard should be prudently considered in this regard.
Summary of Findings
The biggest advantage of the implementation of AASB 16 would be that both finance and the operating lease would be recognized on the balance sheet. It would certainly impact the assets turnover of Wesfarmers along with affecting its interest cover, net income, operating profit, cash flows and various other financial ratios (BDO, 2019).Yet many of the companies do argue that implementation of AASB 16 shall be an enormous, tedious and complicated task. Most of them have already appointed project managers who would ensure that the financial metrics and reports are not being adversely impacted by AASB16. They would make sure that the companies are strong enough in terms of lease portfolio performance. Another impact of AASB 16 is that the definition of a lease agreement is being transformed along with the description of a service agreement.
It implies that some of the agreements which currently pertain to services would become leases and vice versa. So, Wesfarmers should fully evaluate its agreements in order to ensure transparent and fair reporting of leases in its financial statements. The intention of AASB 16 is not to discourage business from utilizing leases but rather to ensure that their method of accounting should be done in the most transparent and fairway. Moreover, when a company has executed a lease agreement which is in its transition period, then numerous reliefs have been provided to the lessees. It is in the case when their accounting has been impacted in the most significant manner (AASB Standard, 2016). Both the lessors and lessees are capable of grandfathering their earlier conclusions. But this option has been provided for all the contracts or none of them. It does not imply that an item which was previously recognized as operating lease can remain off-balance sheet for lessees. It saves the cost and efforts required for reevaluating the entire contract which existed on the date of transition as against the new definition of a lease.
Hence it has been recommended to Wesfarmers that the challenges of preparing for AASB 16 cannot be underestimated. Separate project teams should be established and timelines should be prepared for transitions in the near future. The companies should also focus upon gathering of data, the establishment of systems along with evaluating and communicating the impacts of AASB16. They must also thoroughly consider the availability of transition reliefs resulting from the implementation of AASB16.
The objective of AASB 16 is to make sure that lessors and lessees provide appropriate data which completely represents the transactions of a lease in their financial statements. So, the companies are recommended not to consider its implementation a tedious and cumbersome task (Sacarin, 2017).
Its sole intention is to bring transparency and fairness in the accounting of leases. While implementing AASB 16, the companies are thereby recommended to consider all the facts and circumstances of the lease transactions. They should evaluate the terms and conditions of the contract.
AASB 16 is to consistently apply to all the contracts bearing similar characteristics and situations. It would be applied to a portfolio of leases bearing similar characteristics. The companies are therefore recommended to evaluate that the impact on the financial statements of the portfolio does not differ while implementing AASB 16 to the individual leases in that portfolio (Öztürk and Serçemeli, 2016).
Hence to conclude, it can be said that AASB 16 has been implemented for bringing transparency and fairness in the accounting for lease transactions. It would certainly create an impact on gearing and loan covenants of the company. It would also affect the communications with the shareholders and key ratios of the company along with affecting its remuneration schemes comprising of bonus and share-based payments. Thus AASB 16 has a far-reaching commercial implication so that the implementation of lease becomes a part of the integrated program of introducing changes in the financial reporting. It helps in strengthen the true and fair view of the recorded books of account of company.