Fundamentals of Corporate Finance for Topics- myassignmenthelp

Question: Discuss about theFundamentals of Corporate Finance for General Topics. Answer: Introduction This report discusses the impact that the AASB 17 has had on leasing firms in Australia. The report reviews and critically analyzes the article by Churyk, Reinstein and Lander(2015). The fundamental characteristics of financial information include a variety of qualitative aspects that a firm should meet to be considered to have fulfilled the requirements of AASB. The paper analyzes the impact of the AASB 17 standard on lease on Australian firms. This is because many lease obligations are not recorded on the balance sheet and the current accounting for leases does not adequately represent the economics of lease transactions. The characteristics of financial reporting that the changes on lease standards are based on include; relevance and faithful representation of information (Hancock, Bazley Robinson, 2015). The paper also discusses how the application of the new standards on leases is expected to affect lease reporting and business agreement between the lesser and the lessee. The pa per also evaluates whether the implementation of the standards complies with the financial reporting characteristics identified above. The two fundamental characteristics of financial statements as stated in the framework are; relevance and faithful representation. The characteristic of relevance states that the information that is generated by an accounting system used by an entity should impact on decision making by that particular entity (Deegan, 2013). All the information obtained by an accounting system should be useful to the entity for which the statements are prepared. It involves both content of the financial information and its timeliness. Faithful representation is a concept that indicates that financial information should be produced in an accurate manner and should represent a true and fair condition of the business. The information presented in the statements should be true and accurate as per the date indicated in the reports. These two characteristics of financial statement are the backbone of accounting standards and rules. The AASB 16 standards will begin implementation in the year 2019. The AASB 16 is a change brought to fill the gaps identified by the IASB on the current standards of recording leases by companies. The AASB 16 has already been identified as a change in standards which will have significant impact on the firms. The standards are expected to affect the asset and liabilities ratio and also to affect the terms of contracts between lessors and lessees (National Institute of Accountants Australia, 2015)`. Implementation of the new standards on leases will result to changes in the financial metrics that are used by various users of financial information. The standards propose that both the lessee and the lesser should apply an ROU model to account for leases as well as subleases (CCH Australia Limited, 2013). The lessor and the lessee should classify whether the lease is Type A or Type B. Type A leases are non-property leases such as those involving equipment and cars. The type B leases invo lves property lease such as land and buildings. In type B lease, the lease term is a very little compared to the economic value of the asset being leased. The liability of the lessee to pay rent fee for the leased asset will increase the liability of the lessee. The lessee should recognize the right of the residual asset for the time in which the lease term lasts. On the lessors balance sheet, they are required to apportion part of the leased and recognize any residual asset. The lessor is required to record the right to receive payments to the leased asset as income. The following is a table extracted from IFRS website showing the presentation and requirement on disclosure under AASB 16;property, plant and equipment is used as an example. Lease assets Amount($) Carrying amount of lease assets 25,430 -Aircraft 21,500 Real estate and other assets 3,971 Additions to lease assets 5,487 The following is a maturity analysis of lease liability based on gross cash flow that is not discounted: Lease liability Amount Less than 1 year 4,238 2 years 3,786 3 years 3,460 4 years 3,166 5 years 2,940 6 years 2,453 7 years 2,401 8 years 2,384 9 years 2,359 10 yrs 1,547 Between 10-15 years 1,965 Above 15 years 1,409 Total undiscounted lease liability 32,108 Income statement example Depreciation of lease 2,674 Aircraft 2,278 Real estate and others 396 Interest on rent (1,882) 4,556 Lease payment(Variable) 78 Sublease incomes 59 Gains on sale and transactions on leasebacks 100 Total lease cash spent (4,319) The new lease recording standards will result to increase in net debt and gearing for many companies. This is because, the new rules will result to an increase in reported debt. The Right of Use will be excluded from the financial report in this case and hence resulting to an increase in net debt. The earnings before interest and tax will also increase. This is the operating lease expense will not be included in the profit and loss account (PKF, 2016). The EBITDA will also be affected by the new AASB 16 standards. This is because, the standards eliminate lease rent as an operating expense, and it is recognized as depreciation by the lessee. This will increase EBITDA which may exaggerate the performance of a company. Share based payment scheme may be based on EBITDA and therefore the scheme need to be reviewed and revised. (Loftus, 2013) This is a complex process and it may force a company to incur extra expenses. The following is an example indicating the recording of subscription as a lease in both the income statement and the balance sheet and how it affects EBITDA. Example: Current lease model Income statement Revenue $15,000 expenses -$500 =EBITDA $14,500 Amortization $500 Net income 14,000 Balance sheet Asset Liability Lease fee -$2000 Example showing change in EBITDA using the AASB 16 standards Income statement Revenue $15,000 -Expenses -$500 =EBITDA $14,500 The above shows an increase in EBITDA when the AASB is complied with. The profits will be lower in the initial lease stages and due to high interest of the upfront payments. The change in the lease standards and regulations will have a very huge impact on the general operations of businesses. One of the repercussions is that it will alter the debt agreements between various parties. This is the change in the accounting system will result to changes in lease fees and the lease period can be altered since the new proposed system puts a lot of emphasis on the lease period and the type of lease that the parties are contracted. Under the proposed standards, the lease fee is expected to decrease as the lease period is about to expire. The share based payment metrics will have to be negotiated between parties again since the new accounting rules will affect the payment of lease fee to the lessor. In addition to this, dividend planning may have to change especially among public companies since the income statement and initial equity will be affected by the new accounting format for leases. The other impact that the AASB 16 will result to increase in expenses by companies and hence affect the profit margins of lessee. This is because, the new standards will increase the risk of leasing and the increase in risk will result to increase in leasing rates which will end up affecting many industries such as in transport and financial sector. Banking covenants will also be significantly affected by the AASB 16.This is because requirements such as complying to specific financial ratios such as debt/equity ratio will be affected (Klynveld, Marwick, KPMG, 2015). The costs which are currently recorded as operating expenses will be recorded as interest expense when AASB is complied with. The change in calculation of these ratios will force banks to renegotiate many of their contracts and conflicts may therefore occur between the parties. The standards set by AASB 16 require that companies recognize the right to use assets and lease liabilities. This is referred to as operating leases in the current system of accounting for leases. By recognizing the right to use and lease liability, the balance sheet may end grossing up and hence affecting the asset base and the debts of a firm. This may in turn lead to more companies in Australia requiring audit since the Corporations Act of 2001 firms must meet one of the following three thresholds in order to be audited; Assets in excess of $12.5m,more than 50 employees and revenue of $25 million and above (Carmichael, Whittington, Ray Graham, Lynford, 2012). Compliance with AASB 16 standards will result to adherence to the two basic characteristics of financial records which includes relevance and faithful representation of information. This is because, the AASB 16 is able to fill the gaps that exist in the current lease accounting standards. The AASB 16 requires firms to recognize the right of use and the liability of paying lease fee. Previously the costs of leasing were recognized as operating expenses under the rent expenses account. In the new system, the costs of renting will be recorded as interests expenses (Berk, Harford,Ford, Mollica Finch, 2013). This will ensure that companies leasing an asset recognize all the expenses that are incurred by the firms hence ensuring full compliance with faithful representation of information. The depreciation expenses of the leased asset also have to be recorded and ensure that as the asset is being used, its value does not remain constant and hence disclosing all the relevant accounting infor mation. AASB also requires firms should distinguish leases based on whether the lessee acquires and consumes a significant portion of the related assets during the lease period. In this case, land and buildings and other tangible assets are amortized using the straight line method. The AASB 16 requires that terms of the lease can only be changed if a significant change in factors affecting the economic incentive of the lessee occurs. This may prompt him/her to extend or terminate the contract. The lessee should separate changes in terms that have been agreed to currently and the terms under the previous agreement (Camfferman Zeff, 2015). This is necessary if there are changes in the rent paid to the lesser and hence increasing the liability of the lessee. The changes should be immediately recorded in the income statement. By recording these changes, the standard is in line with the financial records characteristic of relevance and faithful representation. Conclusions AASB 16 was developed to deal with the issues that arise with the current lease recording standards. These issues are related to revenue recognition for lease rent, disclosures, and matching expenses to revenues. These issues were found to cause transactions and reports that did not represent faithful reporting. The AASB 16 is expected to have a major impact on many firms operations. The new standards are also expected to affect ratios such as Debt/equity ratio, EBIT, EBITDA, and interest expense in comparison to the profit. The change in the calculation of these ratios will affect users of financial information such as creditors and investors. Compliance to the AASB 16 is likely to result o breaking of covenant related to banking and the renegotiation of these covenants is costly and may lead to extra expenses and sour relations between parties. Compliance with the AASB 16 will ensure that firms comply with the basic characteristics of financial statements which include relevance an d faithful representation. This in turn improves the quality and reliability of financial reports in general. References Berk, ., Al, J. E., Harford, J., Ford, G., Mollica, V., Finch, N. (2013). Fundamentals of Corporate Finance. Sydney: P.Ed Australia. Camfferman, K., Zeff, S. A. (2015). Aiming for global accounting standards: The International Accounting Standards Board, 2001-2011. Carmichael, D.R., Whittington, O. Ray., Graham, Lynford. (2012). Accountants' Handbook, Financial Accounting and General Topics. John Wiley Sons Inc. CCH Australia Limited,. (2013). Australian superannuation legislation. Deegan, C. M. (2013). Financial Accounting theory. North Ryde: McGraw-Hill Education. Hancock, P., Bazley, M. E., Robinson, P. (2015). Contemporary accounting: A strategic approach for users. Klynveld Peat Marwick Goerdeler., KPMG International Standards Group. (2015). Insights into IFRS: KPMG's practical guide to International Financial Reporting Standards. Loftus, J. (2013). Understanding Australian accounting standards. Milton, Qld: John Wiley and Sons. National Institute of Accountants (Australia). (2015). Corporate accounting and reporting: A practical approach. Frenchs Forest, N.S.W: Pearson Education Australia. PKF, I. (2016). Wiley IFRS 2016: Interpretation and Application of International Financial Reporting Standards.