Recording Inside and Outside Liability

by Using Memo Account to Ensure Completeness of Accounting Entry

Introduction

An academic paper titled “Scenario Analysis of Operating Lease Accounting” drafted by Jennifer Brescia this week trigger a looking inside and outside liability.

Scenario 1

A company apply for a one-year revolving loan from a bank at 31 Dec 2016. The bank approves the loan immediately, and transfer the full loan amount of HK$1,000,000 to the company bank account. The accounting entry is as follow: –

Dr Bank Account     HK$1,000,000

Cr Bank Loan                                       HK$1,000,000

It is straight forward the total loan amount is recognised as a liability.

Scenario 2

With a minor change for the case, the bank will not transfer the loan amount to the company bank account immediate. It is merely a standby credit facility for the customer. The bank commits the company at any business day; the company can request drawdown of the loan amount up to HK$1,000,000. The commitment fee is 1% of HK$1,000,000 payable within one month upon signing the agreement. The accounting entry is as follow: –

Dr Bank Charge             HK$10,000

Cr Account Payable                               HK$10,000

Is the above accounting for loan completed for the purpose of year-end closing with the preparation of full set of financial statements comply with IFRS?

Accounting Analysis

Arguments to Support Accounting is Completed for Both Scenarios

All double entries are well prepared

Financial Statements are auto-generated to cover Balance Sheet, P&L, Cashflow, etc

Arguments to Support Accounting is not Completed for Scenario 2

There are missing of a single entry for scenario 2 – Credit Facility of HK$1,000,000

Note to account of the Financial Statements cannot generate properly

IAS 7.50 (IAS 7 ‐ Cash flow statements) requires disclosure of the amount of undrawn borrowing facilities that may be available for future operating activities and to settle capital commitments, indicating any restriction on the use of these facilities, where it is relevant to users in understanding the financial position and liquidity of the company.

An example, illustrating some of these disclosures is as follows: “The Company holds a committed revolving credit facility of HK$1m which is serving for general corporate and working capital purposes which expire in Dec 2017. As at 31 December 2016 the company had available HK$1m (2015: Nil) of undrawn committed borrowing facilities with a floating charge over the company’s assets; all conditions precedent had been met.”

Base on the example, the suggested accounting entry are as follow: –

Scenario 2

Entry 1 @ 31 Dec 2016

Dr Bank Charge         HK$1,000

Cr Account Payable                      HK$1,000

Entry 2 @ 31 Dec 2016

Cr Credit Facility                           HK$1,000,000

The Account “Credit Facility” is functioned as a memo account which does not form part of double entry mechanism.

Off Balance Sheet Finance

What so cool – balance sheet can have “Off” function? It this means the balance sheet do not have any colour – Transparent? Conceptual correct!

This means a company plans to obtain a new source of finance for general or specific purpose, but the relevant transaction does not record in Balance Sheet. It records as a separate note to account. It is similar to transparent effect, so not easy to detect the existence by using traditional ratio analysis of financial statements.

Off-balance Sheet Finance can be a strategy to remove the colour of specific numbers. Enron case is one of the representative cases of the adoption of off-balance-sheet financing.

The case of Substance and Form as reported by Jennifer Brescia is another case of off-balance sheet finance. However, the case is different from Enron as follows:

Lessors and lessees (lessee who operate business centre) of lease properties are 100% own by a holding company, so it is attributed to inter-company financing. At the consolidated level, all off-balance-sheet financing are eliminated.

The Group has a policy of IFRS compliance. For any new published or amended standards, the Group will prioritise their preference of early adoption.

The management understands how to implement financial transparency to maximise the faithful presentation of financial statements.

Substance Loyalty and Form Attractiveness

The project of early adoption of IFRS 16 Leases is responsible by Substance Loyalty and Form Attractiveness. Substance is responsible for determining accounting rules, and Form is responsible for automation of given accounting rules.

Substance Loyalty (本質忠厚)

Applying an accounting principle of Faithful Representation, Substance planned to maximise the application of the accounting principle – to avoid a further change of accounting policy. He has a review of the history of lease agreements, most of the lease agreements for sub-letting business either 3 or 5 years. For every completion of the lease period, 100% of leases were renewed at similar terms and conditions. He recommended the recognition of Property, Plant and Equipment for the leased property; it is based on the assumption of renewal for every expiry of the lease subject to the remaining useful life of each property.

Form Attractiveness (形式吸引) 

Form expressed her concerns about the complexity of the new accounting rules. She summarises all related calculation steps as follow: –

Determination of amount of Property, Plant and Equipment based on present value of all future lease payments (including all subsequent renewal)

Calculation of Depreciation of Property, Plant and Equipment

Calculation of lease liabilities, repayment related interest expenses

Before the confirmation of the accounting rules, she prepared a scenario analysis report using four different accounting rules of lease accounting for the CFO:-

Scenario 1 (Accrual): Accrual of rental expenses base on lease payment terms

Scenario 2 (IAS 17): Amortisation of lease commitment by lease tenor

Scenario 3 (IFRS 16): Recognition of lease liability by present value of lease commitment

Scenario 4 (Annuity): Recognition of lease liability by present value of estimated lease payment throughout useful life of each property

The CFO Decision

The CFO had a detailed review of the scenario report, minute, and the IFRS.

The lease liability is initially measured at the present value of the lease payments payable over the lease term, discounted at the rate implicit in the lease if that can be readily determined. If that rate cannot be readily determined, the lessee shall use their incremental borrowing rate. [IFRS 16:26]

The CFO considered Substance overinterpreted the IFRS 16 and Conceptual Framework of Financial Report 2010. He considered accounting is attributed to art rather than science. Assuming no change in Legal Form (Lease Agreement) forever, it can be interpreted in a different manner to identify and measure its economic substance by different people over different decades.

Finally, the CFO requested Form Attractiveness to plan for a full implementation of Off-Balance Sheet Accounting using Memo Account although Operating Lease is no longer recognised as off-balance sheet liabilities after implementation of IFRS 16 Lease.

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