This report addresses current accounting practices about leases, pensions, equity, and multiple entities and makes some recommendations on how to improve these practices.
Current Accounting Practices for Leases
In a lease agreement, the lessor is the party that consents to grant the lessee the right to use the asset for a particular period in compensation for periodic rental payments. Accounting standards present two methods of accounting for long-term leases; the operating lease method and the capital lease method. The operating lease method occurs when the lessor benefit from most of the rewards and accepts the risks of ownership. The leased property is reflected as an asset on the books of the lessor. The lessee records in his books the asset that is the subject of the lease agreement together with the lease liability (Stickney, Weil and Stickney, 2009, p. 482).
Under the capital lease method, the lessee bears most of the risks as well as reaps the benefits emanating from ownership of the asset. If the periodic rental payments differ with changes in interest rates, both the leased asset and the lease liability values are adjusted on the lessee’s balance sheet under the capital lease method, while this is not the case under the operating lease method. The capital lease method categorizes the portion of the lease payment related to interest expense as an operating utilization of cash.
The lessee is committed to making payments the same way the payments of credit with a bank could be committed. In addition, the capital lease method and the operating lease method vary in timing, except for the total amount of expense. The operating lease method classifies all the lease payments in each period as an operating utilization of cash on the statement of cash flows (Stickney, Weil & Stickney, 2009, p. 485).
The current approach to accounting practice for leases is significantly regarded as unsatisfactory. Applying this practice requires substantial subjective judgment, for instance, in deducing what is meant by “all the risks and rewards of ownership”. Another problem is that assets and liabilities may not be identified appropriately in the balance sheets of both the lessor and the lessee. To improve on these shortcomings, a single model for assessment and recognition of assets and liabilities under lease arrangements should be developed. In addition, accounting for lease should have a definite way of approaching the rights and obligations that result under a lease agreement.
Current Accounting Practices for Pensions
A pension plan is a contract that calls for a company to pay benefits to employees following their retirement. The contributions from employees and employers are typically paid into a pension fund, which is paid to retirees and invested on behalf of the employees. Pension plans are categorized into two: defined benefit plan and defined contribution plan. Under a defined benefit plan, the employer contributes on an annual basis a predetermined amount needed to fund estimated future pension liability occurring from employment in the present year. The precise amount of the liability will not be recognized until either the retirement or death of the current employees. Under a defined contribution plan, the employer comes up with a fixed annual contribution, generally a percentage of the employees’ gross pay. Furthermore, the amount of the contribution is detailed in an agreement between the company and the employee (Needles, Powers, and Crosson, 2007, p. 592).
According to Schroeder, Clark & Cathy (2011), research has revealed that pension obligations are reported as liabilities. Furthermore, accounting for pension expense and related liabilities is distinct and separate. The calculation of contributions to be made into a pension plan takes into consideration the actuarial present value of accumulated plan benefits, alterations in net assets value during the reporting period, and net assets accessible for benefits.
The defined benefit plan heaps on the employer the burden of precisely approximating the amount that must be contributed to fund a pension plan. This can raise many financial reporting complications; the major one being determining the amount that should be charged to pension expenses in each year even if covered employees are working becomes significantly difficult. A further problem can emerge when the benefit formula is specified and not the benefit amount.
Thus, the periodic pension expense should be estimated by a wider variety of factors, including the percentage of the workforce entitled to the stated benefit plan, the rate of enhancement of salaries under retirement, the length of time that elapses before the release of benefits, the rate of return which will be earned by the pension fund’s management, and the discount rate that will be applied to reflect the present value of the benefits (FASB, 2010). These should serve to significantly reduce volatility in the identification of pension expenses.
Current Accounting Practices regarding equity
The equity method is a technique of accounting whereby the investment is primarily recorded at cost. Further, any capital reserve taking place at the period of acquisition is recognized and added to the cost of the asset. The equity method utilizes the accrual basis to identify the investor’s share of income from investees. Additionally, dividends acquired from an investee are recorded as decreases in the investment account and not as income (Hanif, 2009).
In the equity method of accounting, if an investor owns between 20 and 50 percent of the voting stock of the investee, considerable influence is normally presumed and the equity method is applied. Nevertheless, the vital measure is the ability to extensively influence the investee rather than 20 to 50 percent ownership. If the lack of this ability is confirmed, the equity method should not be practiced regardless of the percentage of shares held. Therefore, the consolidation method is appropriate in such a scenario.
It is also imperative to realize that if a parent company holds more than one-half of a subsidiary company, the equity method of accounting is not permitted. Consolidated companies are thus should substantially merge the financial figures of a collection of their sub-entities into a single statement. It is also recommended that the profits or losses of associate companies should assist to predict the total equity of the company. This total equity then indicates the upward or downward movement of the cost of the investing company.
Current Accounting Practices for Multiple Entities
Accounting for multiple entities centers on five aspects which include consolations and segment reporting, combination, tender offers, push-down accounting, and foreign currency translation for international subsidiaries. The practice for multiple-entity accounting, by comparison to the double-entry bookkeeping and triple entry systems, is significantly different and is mostly applied where one entity operates within several economic spheres.
The model of accounting for multiple entities should be adopted in accounting for a wider range of groupings of economic activities such as monetary, trade policies, fiscal, among others. An application of the multiple-entity accounting system is most obvious at the macroeconomic level than for the accounting field. The method should, therefore, not only be applied to economic entities but it should also be customized to accounting entities.
The discussion presented above examines the current accounting practices in the specified areas. If the recommendations made are adopted, they should go a long way in improving accounting practices as currently applied for leases, multiple entities, pensions, and equity.
FASB. (2010). “Accounting standards update plan accounting—defined contribution pension plans (topic 962)”. Financial Accounting Series. Web.
Hanif. (2009). Accounting: For Ca Ipcc exam. New Delhi: Tata McGraw.
Needles, B, E., Powers, M., & Crosson, S, V. (2007). Principles of accounting. Boston, MA: Cengage Learning.
Schroeder, R, G., Clark, M, W., & Cathey, J, M. (2011). Financial accounting theory and analysis: Text and Cases, (10th ed.). Hoboken, NJ: John Wiley and Sons.
Stickney, C, P., Weil, R.L., & Schipper, K. (2009). Financial accounting: An introduction to concepts, methods, and uses. Mason, Ohio: Cengage Learning.