Conversations with AI: Accounting for Leased Assets by the Lessee

In the below conversation with AI: “Walid” is when I asked Claude 3.5, then it answered in “Claude” section.

I had a conversation with AI “Claude 3.5” regarding IFRS 16 and the requirement to capitalize leased assets by debiting right of use assets and crediting a liability. Although, I encourage all accountants to apply accounting standards, still I find it necessary to discuss conceptual theories in accounting.

Historically, we had operating lease and financing or capital lease. The main rules were used ambiguously by many to record most or all the company leases as operating leases. Then, IFRS 16 came out requiring capitalizing all or most leases as right of use.

To give you a little background, for me it started during my studies for my masters in accounting in 2010, when I had a course on accounting theory. In this course I researched IFRS 16 new proposal regarding financing lease or capital lease new rule as opposed to operating lease that was misused at that time.

After my research I came up with a suggestion that was midway between the operating leases (abused) old standard, and the new all leases capitalised (enforced) standard. My suggestion was and still is to enforce the lessee to capitalize the assets that are used directly in generating revenues to the company, while keeping assets used in “sales general and admin” as operating or financing without enforcing the capitalization clause.

This is different from IFRS 16 that came later with a requirement for the lessee to capitalize all / most assets that are leased regardless of the use.

In short, the theory is that companies will capitalize all factories, equipment, machinery and planes for airlines or shops for retailers or similar. The reason is that the company cannot function without these essential assets that generate the revenues. While the company can function without admin cars by having deliveries and they can rent the headquarters offices or work from home (nowadays). So, companies need not invest in inessential assets, but if they do then they capitalize them.

So, I asked Claude about its opinion on the matter and here is the brief:

Walid:

Do you know about IFRS 16 leasing of assets?

Claude:

Yes, I'm familiar with IFRS 16, which is the International Financial Reporting Standard that deals with the accounting for leases. Here are some key points about IFRS 16:

1. …..
2. Lessee accounting: Lessees recognize a right-of-use asset and a lease liability at the lease commencement date.
3. Lessor accounting: Largely unchanged ....

Walid:

Please elaborate on IFRS 16 eliminating the distinction between operating and finance leases for lessees. Now, most leases are recognized on the balance sheet as a right-of-use asset and a lease liability as compared to previous method.

Claude:

Certainly, I'd be happy to elaborate on this key change introduced by IFRS 16.

Previous method…: Before IFRS 16, leases were classified as either operating leases or finance leases:

1. Operating leases:
   • Not recorded on the balance sheet
   • Lease payments were expensed on a straight-line basis over the lease term
   • Disclosed only in the notes to financial statements
2. Finance leases:
   • Recorded on the balance sheet as an asset and a liability
   • Asset depreciated over its useful life
   • Lease payments split between interest expense and reduction of the lease liability

New method (under IFRS 16): IFRS 16 introduced a single lessee accounting model:

1. Most leases are now recorded on the balance sheet:
   • Right-of-use (ROU) asset: Represents the lessee's right to use the leased asset
   • Lease liability: Represents the obligation to make lease payments
2. Income statement impact:
   • Depreciation expense for the ROU asset
   • Interest expense on the lease liability
3. Exceptions:
   • Short-term leases (12 months or less)
   • Leases of low-value assets

Key differences and implications: ….

Walid:

What is the argument against recording all leases as right to use and liability?

Claude:

There are several arguments against recording all leases as right-of-use assets and liabilities. Here are some of the main points:

1. Economic reality:
   • Some contend that not all leases represent a true financing transaction and that the right-of-use model doesn't always reflect the economic substance of certain lease arrangements.
2. Volatility in financial statements:
   • Regular reassessment of lease liabilities (due to changes in lease terms or index-based payments) can lead to increased volatility in financial statements.
3. Inconsistency with lessor accounting:
   • While lessees now record most leases on-balance sheet, lessor accounting remains largely unchanged, creating an asymmetry in reporting.
4. Industry-specific concerns:
   • Certain industries (e.g., airlines, retail) are disproportionately affected due to their heavy reliance on leasing.

Walid:

in the same spirit of the above let us consider separating "revenue generating assets" that are used in production of "the products or services that the company sells" and assets used in other business operations "sales general and admin". Is there a merit to this among accountants or authorities?

Claude:

This is an interesting concept you're proposing, and it touches on some fundamental principles of accounting and financial reporting. While there isn't a widespread practice of explicitly separating assets in financial statements exactly as you've described, there are some related concepts and discussions in accounting circles. Let's explore this idea:

1. Current practice:
   • Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) don't specifically require separating assets into "revenue generating" and "other business operations" categories.
   • However, there are some related practices and disclosures that provide insight into this kind of distinction.
2. Potential merits of this approach:
   • Enhanced decision-usefulness: Separating assets this way could provide users of financial statements with clearer information about which assets directly contribute to revenue generation.
   • Improved performance analysis: It could facilitate better analysis of asset efficiency and return on investment for core revenue-generating activities.
   • Cost allocation: This separation might aid in more accurate cost allocation and, consequently, in pricing decisions and profitability analysis.
3. Related existing practices:
   • Segment reporting: Companies often disclose information about different business segments, which can include assets used in different parts of the business.
   • Property, plant, and equipment (PP&E) disclosures: Notes to financial statements often provide breakdowns of PP&E by type or function.
   • Cost of goods sold (COGS) vs. SG&A: The income statement already separates expenses related to production from those related to sales, general, and administrative functions.
4. Challenges and considerations:
   • Allocation issues: Many assets serve multiple purposes, making it difficult to clearly categorize them.
   • Complexity: This approach could add complexity to financial reporting and increase the cost of preparing financial statements.
   • Comparability: Without standardized guidelines, comparability between companies might be reduced.
5. Academic and professional discussions:
   • While not exactly in the form you've proposed, there are ongoing discussions in accounting circles about improving asset classification and disclosure to enhance the decision-usefulness of financial statements.
   • Some academics and professionals advocate for more granular breakdowns of assets and their uses in financial reporting.
6. Management accounting perspective:
   • In management accounting (as opposed to financial accounting), this kind of separation is often used internally for decision-making purposes, even if it's not reflected in external financial statements.

While there isn't a widespread movement to adopt this specific categorization in formal financial reporting, the idea aligns with the ongoing efforts to make financial statements more informative and useful for decision-making. As financial reporting continues to evolve, we might see more granular and purpose-oriented asset classifications in the future.

If you're interested in exploring this concept further, you might want to look into academic accounting journals or professional accounting bodies' research publications, where such ideas are often discussed and debated.