Operating leases on Balance Sheet

A lease is an agreement between two parties, a lessor and a lessee. In this agreement, the lessor gives the lessee the right to use an asset in exchange for payments. Usually, it consists of leasing property, machinery, vehicles, or other fixed assets. While the lessor stays the owner of the leased asset, the lessee gets to benefit from using it.

What is an Operating Lease?

An operating lease is a lease agreement in which the lessor provides the lessee with the right to use an asset for a short duration. As mentioned above, like other leases, operating leases do not come with ownership of the asset but only with the right to use them. Under the latest accounting standards, companies must classify any asset that they lease for less than 12 months as operating leases.

In contrast, companies that lease assets for more than 12 months must report those assets as capital leases. In the past, there were various requirements for companies to differentiate between operating and capital leases. However, the latest accounting standards have made the classification easier by requiring companies to classify assets based on their time of lease. These are the assets the companies capitalize and show on their Balance Sheets.

Operating leases on Balance Sheet

In the past, because the lessee did not, in substance, own the asset in an operating lease, the leased asset did not appear on the lessee’s Balance Sheet. Instead, the lessee only recorded regular operating lease payments as an expense on their Income Statements. It allowed companies to lease major assets to use in operations and not report them in the Balance Sheet, further allowing them to show better position and performance.

However, under major accounting standards, the treatment of operating leases has changed. Recently, accounting standards started requiring companies and businesses to show operating leases on their Balance Sheet. They also state that companies must record a liability for operating leases with a corresponding asset known as the ‘Right of Use’ assets’ on their Balance Sheets.

Under US GAAP, companies still need to record the operating lease payments as operating lease rent. However, under IFRS, the treatment for recording the lease rent expense has altered. With the introduction of IFRS 16, the accounting standard requires companies following the IFRS to split operating lease rent payments into two components. These are the depreciation and interest components.

The only change these accounting standards have brought is to the presentation of operating leases. As mentioned, companies only need to split the expense, not change it. Therefore, the profits of companies stay unchanged due to the change in the accounting standards. However, these standards have changed the way companies record operating leases in their Balance Sheets.

Recognizing Right of Use Asset

As mentioned above, a right of use asset refers to the amount the companies must recognize on their balance sheet for any assets that they lease under a lease contract. It is the asset that companies must present on the face of their Balance Sheet. When a company obtains a leased asset, it must recognize it as a right of use asset initially at its cost.

The cost of the right of use asset consists of three components. Firstly, it includes the amount of initial recognition of lease liability, which represents the present value of lease payments determined at the rate of interest implicit in the lease. If the interest rate is not available, the company can use its incremental borrowing rate.

Secondly, it consists of the lease payments made before the commencement date after subtracting any lease incentives. It also includes any initial direct costs and the cost of dismantling and restoring the asset, if any. When a company recognizes an asset as the right of use initially, the subsequent accounting treatment is the same as any other acquired asset.

Journal entry

After calculating the cost of the right of use asset, the company can use the following journal entry to recognize it.

DrRight of use assetx
CrLease liabilityx

The company can then depreciate the asset as usual. In case of an operating lease, the company must split the rental payments made into two components, as mentioned above.

Example

A company, ABC Co., leases and asset for five years. The present value of the lease liability of the leased asset, as calculated by the company, equals $100,000. The initial direct cost of the lease is $10,000, which ABC Co. pays in cash. Therefore, ABC Co. can use the following accounting entry to recognize the asset in its Balance Sheet.

DrRight of use asset$110,000
CrLease liability$100,000
CrCash$10,000

The right of use asset will appear in ABC Co.’s Balance Sheet at the end of the accounting period, after calculating and subtracting the related depreciation expense from it.

Conclusion

An operating lease is a type of lease agreement in which a lessor provides the right of use of an asset to the lessee. The accounting treatment of operating leases has changed from the past. The new accounting treatment requires companies to recognize an asset called the ‘right of use asset’ in their balance sheet for leases that have a life of more than 12 months. It also requires them to show these assets on their Balance Sheet, unlike in the past when it was omitted.

Change in Accounting Policy (Explanation and Examples)

Change in Accounting Policy:

Accounting Policies refer to the specific principles, rules, conventions and practices employed by an entity in the preparation and presentation of financial statements. The entity shall select and apply the accounting policies consistently unless interpretation or by other reasons, it is required to change to different accounting policies. Various accounting policies happen in transactions related to:

  • Valuation of Inventory
  • Valuation of fixed assets
  • Valuation of investments
  • Treatment of goodwill
  • Treatment of contingent liabilities

As a general rule, the changes in the accounting policies must be applied retrospectively in the financial statements. It means the company must adjust all the comparative amounts of prior years in the current year due to such change in the financial statement.

The change in accounting policies is required if:

  • It is required by the statute
  • It results into a better and appropriate presentation
  • The change will provide more useful, relevant and reliable information of financial statements about the effects of transactions, events, financial performance, etc

When there is a change in accounting policy, the company has to disclose the following facts:

  • Disclose the changes that would have a material effect in this period or upcoming periods
  • In case of the material effect of the change in this period, calculate and disclose the amount by

which any item in the books of account is affected by such change

  • Nature of change
  • Reasons for change
  • Where the retrospective application is impracticable, the reasons for such impracticability.

If change is due to a new standard, transitional provisions should be applied. If transitional provisions are not given, the new policy should be applied retrospectively. This standard state that the significant accounting policies adopted by the company should form part of the financial statements.

Accounting policyAccounting principles
Inventory costingWeighted average methodFirst In First Out methodLast in First out
Method of depreciationStraight-line methodWritten down methodProduction unit’s method
Valuation of Fixed assetsAcquisition priceRevaluation

When the change in accounting policy is applied with retrospective effect, the company shall adjust the opening balance of each affected component e.g., depreciation as the policy has been applied from the very beginning. When it is impracticable to determine the cumulative effect due to the change in accounting policy, the entity shall adjust the transactions in a manner to apply the changes prospectively from the earliest time possible.

Sample of fixed assets accounting policy:

                                                                    ABC Ltd.

                                                     Fixed Assets Accounting Policy

  • Purpose: This policy establishes the procedure of recording the newly purchased fixed assets and old fixed assets information and it elaborates the process of determining the valuation of the fixed assets at the historical price in the annual financial statements of ABC Ltd.
  • Fixed Assets Definition: It is defined as part of the property which has a useful life of more than 12 months and was purchased for a cost of Rs. 75000 or more. Such assets must be depreciated at the rate of 20 % per annum.
  • Register of Fixed Assets: The list of all the fixed assets of the organization should be entered in the fixed assets register and it shall be reviewed half-yearly by the Board of Directors.

The register must include the following information:

  • Code number of the asset
  • Description of the asset
  • Asset class
  • Asset’s cost price
  • Asset’s useful life
  • Asset’s salvage value if any
  • The threshold value for capitalization:

Any fixed asset with a cost of Rs 75000 or more shall be included in fixed assets. The fixed assets with a value less than Rs 75000 will be charged to expenses in the financial accounts of the company.

  • Useful life:

The useful life is the estimated period during which the assets provide benefits to the company. The factors such as depreciation, obsolescence, wear and tear are taken into account for the calculation of useful life. The policy has specified the following useful lives for the following fixed assets

AssetsUseful life
Computer2 years
Furniture and fixtures6 years
Office equipment7 years
Vehicles5 years

Adopted this the 5th of December by board vote via teleconference: Yes/Approve: David, Leena & Pruthvi

No/Disapprove: None

Not Voting: None

Example

Let us understand the change in accounting policy and its effect on the financial statement with the help of the following example:

On 1st April 2015, Hari purchased a machine for Rs. 100,000. Depreciation was charged at 20% per annum on SLM. From 1st April 2018, he decided to switch to WDV retrospectively. Calculate the effect of this change. (SLM – Straight Line method & WDV – Written down method)

Calculation of depreciation using SLM:

Depreciation= 100000* 20/100*3=60000

Calculation of depreciation using WDV

Depreciation for 15/16= 100000*20/100= 20000

WDV value= 100000-20000=80000

Depreciation for 16/17= 80000*20/100=16000

WDV value= 80000-16000= 64000

Depreciation for 17/18= 64000*20/100= 12800

WDV value= 64000-12800= 51200

Total depreciation as per WDV= 20000+ 16000+12800= 48800

Total depreciation as per SLM= 60000

So, the adjusting entry would be

DateParticularsDebit ($)Credit ($)
 Profit and Loss A/C Dr  11200 
            To Depreciation A/C            11200
 (To record adjusting entry for change  

What is Cash Credit?

Cash Credit Meaning

Cash credit is one of the methods of financing provided by the banks and financial institutions to their business customers by taking the customers’ collateral in exchange for cash. It is not often offered to individual customers.

The cash credit limit is based on the borrower’s need and their payment capacity as agreed with the bank which is similar to others bank’s facilities. Banks calculate the net trading assets of the company and finance 70% of the net trading assets.

What are the collaterals to apply for cash credit?

  • Stock
  • Bond
  • Property

How to calculation cash credit limit?

As mentioned above, the bank or financial institution will provide the cash credit to their customers for certain percentages of the total value of collateral.

Here is how to calculate the cash credit limit,

Value of stockXXX
Value of debtorsXXX
 (-) Value of creditorsXXX
Net trading assetsXXX
Cash credit limit (Borrowing power)70% of net trading assets

The limits for such cash credits are sanctioned and interest is charged on the loan amount actually used by the borrower. The security of cash credit is arranged by means of hypothecation of stock, pledge.

The features of cash credit are as follows:

  • This loan is meant to meet the working capital requirements of the company. It is generally given for one year or period less than a year.
  • It is given against a collateral security. The banks employ that the market value of the security should be 120% or more than the value of the loan.
  • Interest is charged on the amount of loan used and not on the limit sanctioned.

The advantages of cash credit are as follows:

  • It is useful short-term source of financing.
  • Interest is charged on the utilized amount only.
  • It can be sanctioned easily and quickly and is hassle free.

The disadvantages of cash credit are given below:

  • Delay in payment of cash credit disturbs their credit planning and credit score of the banks.
  • Such loans are given on the basis of ratio analysis of its financial statements and audit report hence it becomes difficult for small firms to obtain the loan.
  • The cash credit system makes difficult for bank to have any control over the end use of the loan amount.
  • The cash credit system leaves enough room for the borrowers to take loans from multiple banks which might result in banks getting cheated.
  • It is renewed from year to year unless cancelled and the loan with interest due amount being paid in final settlement. Every year, renewal procedure shall be followed and almost all procedures are followed as if new loan is sanctioned.

Process of cash credit loan:

  • Application for the loan: The application is filled by the eligible borrower with his personal details, loan amount, photo and identity documents.
  • The loan proposal is prepared by the bank staff. He gathers information about the collateral of the land i.e., land or building. He verifies the ownership of the collateral through the land ownership document or property registration certificate.
  • Calculation of the EMI of the loan and assessment of the paying capacity of the borrower. The staff estimates yearly income of the borrower by compiling his income details against the salary slips, agricultural income verified by the local government, rental income and deductions of his yearly expenses including the safety margin of 10% (assume). His net income is finally arrived at.
  • The ratio of net income and EMI of loan is calculated. If the net income is twice or more than the EMI of the loan, the loan can be granted among other factors such as location and valuation of land. The land must be in the name of borrower or any immediate family member.
  • If the above conditions are met, the loan can be granted. One or more guarantors are required to sign in the guarantee agreement that if the borrower fails to pay the loan, the guarantor would be liable to pay.
  • The guarantor agreement is prepared wherein his identity document number, parent’s name and borrower’s name is mentioned and the guarantor agrees to pay the bank in case of failure of payment by the borrower. It is mentioned in the agreement that banks can realize the loan amount by the auction of the collateral or seizure of the bank accounts with other banks.
  • The hypothecation agreement is prepared wherein the description of the valuation and content of stock is mentioned with the loan amount and it is duly signed by the borrower with the two witnesses.
  • Internal loan deed is prepared as an agreement between bank and borrowing party. The internal loan deed entails the loan amount, address and identity of the borrower, details of the owner, measurement and location of land kept as collateral. The deed is signed by the borrower, the witnesses and bank.
  • The recovery from the receivable’s agreement is prepared to assign the receivables of the company in the name of bank in case the borrower fails to pay amount in time. The bank can realize from the debtors of the borrower if the borrower defaults in payment.

How does cash credit work?

Cash credit is normally offer to the company that short of cash to support it operation. And to get the cash credit the company needs to apply to the bank or financial institution that offer such facility. Normally, the bank will need the customers to have the collateral to secure the cash credit.

The bank will also need to assess the others factors other the collateral to ensure that the customer could pay back the com cash that it uses to withdraw.

The bank normally offers the cash credit for the certain amount of the collateral of the company. For example, up to 80% of the collateral.

This kind of facilities is kind of the short-term and the interest rate is normally higher than the loan, but it is depending on the bank. Interest is only when the cash credit is withdrawn by the customers.

What’s a Credit Card Cash Advance?

After the bank approves the cash credit, the customers could normally have the cash credit card that will issue by the bank. This cash credit card could be used to advance the cash from the bank up to the limit amount that the bank approves. However, it is depending on the bank. Some bank offers the credit card to easily advance or withdraw the cash. And some bank does not.

Accounting for Construction Contracts

Overview

Construction businesses tend to be a lot different because of several different reasons that mainly occur because of relative difficulty to account for several different things. In this regard, it can be seen that contractors, alongside accountant, tend to find it confusing as to the correct treatment and categorization of these resources that can possibly help companies in achieving accurate record-keeping that can ensure that there is proper clarity regarding the financial position of the respective organization at the end of the financial year.

Additionally, since construction projects spread over a timeline of more than one year, they are classified as long term projects. As a result, there is a need to have a relatively different accounting setup that can ensure proper, and specific accounting standards that are solely attributable to construction contracts.

Nature

In order to account for construction contracts, there have been several different rules that have been put forth in order to ensure proper classification of these contracts. Generally, there are two accepted accounting methods that are utilized to account for construction contracts, and they are referred to as percentage of completion method, and the completed contract method.

The construction contract can simply be defined as a contract that is specifically designed and negotiated upon construction of an asset, or any specific projects. This is broadly covered in IAS (International Accounting Standards) 15, which covers several different components. The construction contracts are supposed to be accounted for based on this rationale, in order to bring uniformity across all construction businesses (or organizations that have construction projects in their domain), and make it as transparent and easy to comprehend as possible.

Revenue Recognition Principle

Revenue Recognition principle requires revenue to be recorded only when it is absolutely certain that the amount would be received by the company. In this regard, IFRS 15 sets out certain rules and regulations that provide a framework for construction revenue to be recognized if the following conditions are duly met. These conditions are as follows:

  • Total Contract Revenue should be measured in a reliable way. The measurement of revenue earned from construction contracts should not be vague, or ambiguous.
  • The revenue flow should suggest that the economic benefits that are associated with the contract itself are likely to pass on to the seller. This is required for contract revenue to be recognized properly in the financial statements.
  • The sellers cost that is required to complete the contract, in addition to the stage of contract completion at the end of the reporting period should be measured in a reliable manner. Since these are relatively long term projects, the percentage of completion, and the extent to which they are completed should be clear.
  • The seller’s costs can also be attributable to the contract which can be clearly identified, described, as well as measured in a reliable manner. This is mainly to ensure that actual costs that are incurred can accurately be compared with the previous estimates.

Furthermore, as far as the revenue recognition part is concerned in Construction Contracts, IFRS 15 also provides three methods that can be used in order to properly classify and recognize the revenue that is earned. This includes the following:

  • The extent (or proportion) of contract costs that are incurred for work that is performed to complete the project in a successful manner.
  • Surveys of work performed
  • The extent to which physical construction work is completed out of the overall scope of the contract work.

Contract Assets

Contract Assets are supposed to be recognized when performance obligations are duly satisfied, but the payment has still not been made because it is contingent on several other factors, that mainly vest on other performance obligations that need to be fulfilled. In other words, the payout of this particular item is not contingent on the completion of this particular obligation, but some other obligation that needs to be honored too.

They are different from trade receivables because of the fact that trade receivables depict an unconditional right to receive the particular revenue from the other party. There is a greater credit risk involved in contract assets which is not available otherwise.

Contract Liabilities

On the contrary, Contract Liabilities are disclosed on the Balance Sheet when a payment from a customer has been received, even before a performance obligation is carried out. In this regard, the treatment of contract liabilities and unearned revenue tends to be the same, because this means that the amount has been received for the work that is yet to be executed.

Example

In order to understand Contract Assets, and Contract Liabilities better, let’s take a look at the following illustration:

Illustration 1

A telecommunications company has a package where the customer gets a phone, as well as operational service charges for cellular network that spans over a year. The contract is structured as such that the basic flat rate to subscribe the package is $100. This is independent of any cellular network charges.

Additionally, the customer also has to pay $20 a month, for 12 months as part of the contract obligation. The customer can back out any time, but the down payment (i.e. $100 will stay fixed as it is). The entry to record this particular transaction is going to be as follows.

DateAccount Title and DescriptionDebitCredit
1 July 2019Accounts Receivable100 
 Contract Asset240 
 Revenue 340

Illustration 2

In the same scenario as the one above, if the customer would have paid the entire amount upfront, then the following transaction would have to be made:

DateAccount Title and DescriptionDebitCredit
1 July 2019Cash340 
 Contract Asset 240
 Revenue 100

Conclusion

Accounting for construction contracts tends to be challenging, because of different variations and factors that are involved in the overall process. However, with revenue recognition being the main cause of concern for accountants in this regard, it is important for accountants to properly classify all transactions, in addition to having absolute clarity regarding contract assets and contract liabilities.