Discuss the impact of capitalize operating leases on financial statement.

Lease can be defined as a contractual agreement between lessor and lessee that transfers the
right to use of asset to lessee from lessor, but the ownership remains to lessor for a certain period. In
the return, lessee submits lease payments to lessor[ CITATION Fre08 \l 1033 ]. Lease accounting is
very complicated, because there are many different types of assets that can be leased[ CITATION
Fre08 \l 1033 ].

Based on the outdated Australian Accounting Standard Board (AASB 117), the differences
between finance and operating leases is made with the treatment of both being quite
different[CITATION XuW17 \p 35 \l 1033 ]. As for finance lease, the leased asset and liability are
recognized, while operating leases are not recognized in balance sheet or statement of financial
position as it will only reflect in the lessee’s statement of profit or loss[ CITATION Mik16 \l 1033 ].
So, this provides flexibility to companies for using operating leases to undertake fixed cost capital
expenditures[CITATION XuW17 \p 34 \l 1033 ]. This gives an unfair representation of a company’s
financial position, as the balance sheets do not reflect operating leases[CITATION XuW17 \p 34 \l
1033 ].

In 2010, the recommendation of the ‘right of use’ concept was proposed by the International
Accounting Standard Board (IASB) in Exposure Draft 1 (ED1) and Exposure Draft 2 (ED2) in May
2013[CITATION XuW17 \p 35 \l 1033 ]. In 2016 February, Australia was adopted IFRS 16 and
AASB 16[CITATION XuW17 \p 35 \l 1033 ]. Both IFRS 16 and AASB 16 will be applicable to
annual reporting periods beginning on or after 1 January 2019[CITATION XuW17 \p 35 \l 1033 ].
The difference between AASB 117 and AASB 16 is the amounts currently classified as operating
leases and not recognized on balance sheet will now be recognized as an asset[CITATION XuW17 \p
35 \l 1033 ].

The impact of capitalizing operating leases on financial statement that caused by AASB 16,
including balance sheet or statement of financial position, income statement and cash flow
statement[ CITATION XuW17 \l 1033 ]. The first impact on financial statement in balance sheet after
capitalizing operating leases, is both total assets and total liabilities will increase as requirement of
recognizing as a right of use asset and liability[CITATION NSW17 \l 1033 ]. The equity will decrease
as the carrying amount of lease assets is reducing faster than the carrying amount of lease liabilities[
CITATION NSW17 \l 1033 ].
 Moreover, the second impact is income statement. Under AASB 117, when interest expense
does not minus from revenue, the EBIT will be higher due to the depreciation expense are likely to
be lower than operating lease expense[ CITATION PwC16 \l 1033 ]. The EBITDA will be expected to
be higher because of operating lease costs included in operating expenses and will be replaced by
interest and depreciation expenses that are not deducted from revenue[ CITATION NSW17 \l 1033 ].
A firm with stable portfolio leases, the total expense recognized by capitalizing operating leases is
greater than the off-balance-sheet lease expense incurred in the early periods of the lease
terms[ CITATION XuW17 \l 1033 ]. However, the interest charged for lease liabilities is reduced, the
effect on the income statement will be reversed in later periods. On the other hand, the annual profit
before tax will depend on the lease portfolio[ CITATION NSW17 \l 1033 ].

Furthermore, cash flow statement is known as one of the impact of capitalizing operating
lease. Under AASB 16, outflow of operating activities is expected to be less, although interest
expense is smaller than operating lease expense[ CITATION PwC16 \l 1033 ]. In the meantime, the
outflow of financing activities would be higher than previous since the principal repayments are
included[ CITATION PwC16 \l 1033 ]. Besides, the total cash flow is remained unchanged due to
identical cash repayment[ CITATION NSW17 \l 1033 ]. Refer to research that done by Xu, Davidson
and Cheong (2017), industries to the extent also affected by capitalizing operating leases.

In conclusion, the right-of-use method for leases is in coherence with the financial reporting
conceptual framework and aimed to improves the transparency of financial statements under AASB
16[ CITATION XuW17 \l 1033 ]. It enhances the transparency of accounting practices by reducing the
ability to use complex lease agreements to shift material information from financial
statements[ CITATION XuW17 \l 1033 ].
Reference Lists

Frecka, T. J., 2008, ‘Ethical Issues in Financial Reporting: Is Intentional Structuring of Lease
Contracts to Avoid Capitalization Unethical?’, Journal of Business Ethics, vol.80, no.1, pp45-59.

Mikkonen, R. S. K., 2016, ‘Value Relevance of Operating Leases – Empirical Evidence from Listed
Companies on Air Transportation Industry’, Master’s Degree thesis, School of Business, Aalto
University, accessed 28/5/2019.

NSW Government 2017, Guidance For AASB 16 Leases, The Treasury, Sydney.

PwC 2016, ‘In Depth A Look At Current Financial Reporting Issues’, PwC.

Xu, W, Davidson, R & Cheong, C 2017, ‘Converting Financial Statements: Operating To

Capitalized Leases’, Pacific Accounting Review, vol.29, no.1, pp34-54.