That transaction contains lease arrangement!

Reference:

-          IFRIC4

-          Intermediate accounting – Kieso Weygandt and Warfield (2012)

As stated in IFRIC 4, an entity may enter into an arrangement, comprising a transaction or a series of related transactions that does not take legal form of a lease but conveys a right to use an asset (for example an item of property, plant or equipment) in return for a payment or series or payments.

To summarize the statement, sometimes an entity may enter into transactions that contain lease. Based on my experience, this type of transactions usually happens in automotive or other related industries. For example, there is a Company XXX that produces lamps for motorcycle and car-makers. This Company needs to prepare a specific dies to produce these lamps. These dies are prepared based on the design of each lamp therefore each type of lamp needs a specific dies. The Company charges the cost to prepare these dies to the customers by adding the depreciation cost into the sales price.

Usually the Company treats these transactions as ordinary sales transactions. However, there is lease arrangement inside this transaction.

Based on IFRIC 4, to determine whether an arrangement is or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether:

(a)   Fulfillment of the arrangement is dependent on the use of a specific asset or assets

(b)   The arrangement conveys a right to use the asset

Analyzing the previous condition of Company XXX, we can see that the sales transaction contains lease arrangement because:

-          The arrangement is dependent on the use of a specific dies.

Lamp type 010 for Customer A needs dies specifically prepared for lamp type 010.

-          The arrangement conveys a right to use the asset

Dies prepared for type 010 for Customer A may not be used to produce lamps for Customer B. Because this dies was prepared based on lamp design from Customer A. Producing lamps for Customer B using Customer A’s dies may breach the confidentiality arrangement between Company X and Customer A.

Then what do we do if these sales transactions contain lease arrangement?

Assessment should be made to determine whether the sales transactions are classified as financial or operating lease. Based on IFRS 17 (lease), a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

FASB gives this guidance, as explained in Kieso, Weygandt and Warfield (2012):

A lease arrangement is classified as financial lease if one or more of these criteria is met:

The arrangement between Company XXX and Customer A must be assessed using the above 4 criteria.

What to do after the lease category assessment?

The results might be:

1.     The arrangement is categorized as operating lease

The Company treats the cost of dies usage as common rent. The cost of rent is charged through the depreciation cost which is included into the sales price.

2.     The arrangement is categorized as finance lease

Company may not recognize the dies as the Company’s assets, but it needs to recognize this as lease receivable instead. The Company also needs to prepare the amortization schedule for the arrangement. The amortization schedule is similar to the amortization schedule for loan. Please read the reference for finance lease treatment to learn further about the calculation.

Auditing - Property, Plant and Equipment

How do auditors audit property, plant and equipment (PPE) or the one used to be called fixed assets?

Since audit is an art, each accounting firm has their own procedures to audit property, plant and equipment. Different audit might point different significant points to audit each area.

Here is a quick look based on my experience:

There are several mandatory procedures that we have to perform:

1.       Obtain the list of PPE accounts

This list consists of all outstanding fixed assets.

Purpose: to understand the nature of outstanding PPE and for recalculating the depreciation expense (related with audit procedures for operating expense).

2.       Obtain the list and movement of PPE

Agree listing to PPE account balance

Client should provide the list of all PPE owned by the Company. These fixed assets should be categorized based on the PPE accounts so that we can tie up the total amount of assets in PPE listing to the balance of PPE account.

We also have to prepare movement of PPE. This movement will be presented in notes to financial statement. The general PPE movement format is usually like this:

Coloumn beginning balance consists of the amount of PPE on the beginning of the financial year. For example, the audited financial year is 1 January 2012 - 31 December 2012, beginning balance will consists the amount of PPE on 1 January 2012.

Coloumn additions consists of the amount of PPE purchase during the year.

Coloumn reclassifications informs any reclassification between PPE accounts. The general reclassification in PPE is from Construction in Progress to each PPE accounts (such as Building or Machinery).

Coloumn disposal includes all disposal due to sales or due to termination of use.

 

Understanding PPE nature

While receiving the listing, auditors need to perform scanning analytic as well. In this procedure, we scan the items of PPE so that we can understand the nature of assets owned by the Company. We need to be aware of any significant variance during the year. For example, significant increase in Machine category existed during the year. We need to perform inquiry to client wheter there are any special reasons that triggers the signficant increase (such as the opening of new plant, addition of product line). This understanding will enrich our understanding of the Company as a whole.

The same goes for disposal. If there were significant disposals during the year, we need to perform inquiry to client to understand the reasons of disposal. For example, if the reason is because the machines broke down, we need to assess whether this condition triggers to the impairment of other assets, whether the estimated useful life set by the management is proper or not.

 

3.       Understand and evaluate accounting policies

These accounting policies are important because they will affect the next procedures for PPE and also presented in the notes to financial statements.

There are some important accounting policies for PPE:

-          Capitalization policy

Some companies apply minimum amount for PPE. For example, for assets with price below USD 1,000 will be directly expensed

-          Depreciation method: straight line, double declining balance or sum of year digit

-          Estimated useful life for each fixed assets category

-          Capitalization of borrowing cost

 

4.       Test depreciation expense

There are two ways to test depreciation expense:

a.       By recalculating the depreciation expense

b.      Analytical procedures

In this option, we will try to get the triggers that will affect the balance of depreciation expense. For example, we will look at the connection between the increase of depreciation expense with the addition of PPE.

 

5.       Test additions of PPE

In this testing, the population includes all additions of PPE.

Audit procedures that are usually used in test additions of PPE are analytical scanning for significant additions, pick samples and vouch to documents.

The main assertions that we want to capture in test additions are: accuracy and existence.

Make sure that all PPE additions recorded during the year are proper:

-          How they calculate PPE additions in foreign currency?

Small difference of exchange rate used might triggers significant difference if the PPE additions during the year are significant.

-          Have they used proper capitalization policy?

-          Have they recorded the addition in the proper timing? (this will affect the depreciation)

 

6.       Test transfer of construction in progress (CIP)

Population in this testing includes all off CIP transfer to other PPE categories during the year.

Audit procedures that are usually used in the testing are analytical scanning for significant additions, pick samples and vouch to documents.

Most important document to vouch in this testing is: hand over / completion report. This document will trigger the transfer of CIP. Date of CIP transfer has to be based on this document. If the date of CIP transfer is not based on that document, we may not jump to conclusion, but we need to inquiry further to client.

For example: the Company is constructing a new production line which consists of Machine A, B and C. The Company purchase Machine A, B and C on 30 August 2014. Machine A and B have been completely installed on 2 Oct 2014, however, machine C has just been completely installed on 1 Nov 2014. After machine C is completely installed, the product line is ready to be used.

How should we record the transactions?

 

30 August 2014

CIP – Machine A

CIP – Machine B

CIP – Machine C

Cash/ AP

 

2 Oct 2014

No journal entries. (Machine A and B are completely installed, but not yet ready to use since the production line is not yet ready).

 

1 Nov 2014 (transferring the CIP to Machine)

Machine A

Machine B

Machine C

CIP – Machine A

CIP – Machine B

CIP – Machine C

 

7.       Examine repairs and maintenance

In this testing, the main purpose is to make sure that the Company has followed the proper capitalization policy. Make sure that:

-          The transactions only include expenses that do not increase the value of assets.

-          Some expenses may increase the value of the assets. However, if the amounts are considered immaterial based on the Company’s capitalization policies, they can be directly expensed.

Note: the above explanation is based on my own experience. Any inputs and opinions are appreciated. :)

Incoterms

Incoterms are the commercial terms defined by International Chamber of Commerce which are widely used for global transactions.
These terms define the responsibility for the carriage of goods, risk transfer and delivery cost.
They are important for global transactions to determine the responsibility of parties engaged in the agreement. As for auditor, these terms are key in determining when the transfer of risk takes place.

ICC has published the explanation regarding these terms.
The explanation is in English, please refer to the link: http://www.tradev.net/Downloads/Tools/incotermscolorchart.pdf

Incoterms adalah istilah-istilah komersial yang telah ditentukan oleh International Chamber of Commerce. Istilah-istilah ini telah banyak digunakan dalam perdagangan global.
Incoterms merujuk pada penentuan kewajiban dalam pengangkutan barang, transfer resiko dan biaya dalam pengiriman barang.
Istilah-istilah ini penting bagi para pelaku transaksi ekspor-impor dan tentunya para auditor. Hanya fokusnya saja yang berbeda.
Untuk para auditor, fokusnya terletak pada perpindahan resiko atas barang yang dijual.

Incoterms dapat dibagi menjadi beberapa group besar:

Group E

Dalam group E, penjual meminimalisir resiko mereka karena barang hanya dijual di tempat penjual. Yang artinya biaya pengangkutan dan pengiriman barang menjadi kewajiban customer dan resiko di transfer pada saat barang keluar dari warehouse penjual.
Jenis yang ada di group E:
- EXW (Ex Works)

Group F

Dalam group F, penjual lah yang mengatur pengangkutan dan pengiriman barang sebelum barang di ekspor ke pembeli.
Ada beberapa jenis incoterms yang termasuk dalam group ini:
- FCA (Free Carrier)
Pengangkutan diurus oleh pembeli/penjual atas nama pembeli
Resiko di transfer dari penjual ke pembeli ketika barang diserahkan pada kurir di tempat yang telah ditentukan.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah diserahkan pada kurir tersebut.

- FAS (Free Alongside Ship)
Pengangkutan diurus oleh pembeli
Resiko di transfer dari penjual ke pembeli ketika barang diletakkan di pelabuhan (sebelum naik ke kapal).
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah diletakkan di pelabuhan (sebelum naik ke kapal).

- FOB (Free On Board)
Pengangkutan diurus oleh pembeli
Resiko di transfer dari penjual ke pembeli ketika barang dinaikkan ke kapal.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang dinaikkan ke kapal..

Group C

Dalam group C, penjual mengurus dan membayar pengangkutan dan pengiriman namun resiko atas pengiriman masih menjadi tanggungan pembeli.
Ada beberapa jenis incoterms yang termasuk dalam group ini:
- CFR (Cost and Freight)
Pengangkutan diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang dinaikkan ke kapal.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang telah sampai di pelabuhan tujuan.

- CIF (Cost Insurance Freight)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang dinaikkan ke kapal.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang telah sampai di pelabuhan tujuan.

- CPT (Carriage Paid To)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang telah diserahkan oleh penjual kepada kurir
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang telah sampai di pelabuhan tujuan.

- CIP (Carriage and Insurance Paid)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang telah diserahkan oleh penjual kepada kurir
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang telah sampai di pelabuhan tujuan.

Group D

Pada group ini, resiko penjual menjadi maksimal karena biaya dan resiko berpindah ketika barang sudah diantarkan pada tempat yang telah ditentukan.
Ada beberapa jenis incoterms yang termasuk dalam group ini:
- DAF (Delivered At Frontier)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang telah diantarkan ke perbatasan negara.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang telah sampai di perbatasan negara.

- DAF (Delivered Ex Ship)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang keluar dari kapal dan diserahkan ke pembeli.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang keluar dari kapal dan diserahkan ke pembeli.

- DAF (Delivered Ex Quay)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang sampai di dermaga dan diserahkan ke pembeli.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang sampai di dermaga dan diserahkan ke pembeli.

- DAF (Delivered Duty Unpaid)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang diserahkan ke pembeli.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang diserahkan ke pembeli.
Biaya cukai tidak dibayarkan oleh penjual.


- DAF (Delivered Duty Paid)
Pengangkutan dan asuransi diurus oleh penjual.
Resiko di transfer dari penjual ke pembeli ketika barang diserahkan ke pembeli.
Biaya pengiriman menjadi kewajiban pembeli ketika barang telah ketika barang diserahkan ke pembeli.
Biaya cukai dibayarkan oleh penjual.

Anda dapat juga mengakses link ini: http://www.tradev.net/Downloads/Tools/incotermscolorchart.pdf
Pada link website disertakan ilustrasi yang dapat membantu.

NON-BANK FINANCIAL INSTITUTIONS: Backup Facilities?

NON-BANK FINANCIAL INSTITUTIONS: Backup Facilities?

”What we perceived in the United States in 1998 may reflect an important general principle: Multiple alternatives to transform an economy’s savings into capital investment act as backup facilities should the primary form of intermediation fail. In 1998 in the United States, banking replaced the capital markets. Far more often it has been the other way around, as it was most recently in the United Sates a decade ago.”

(Alan Greenspan: 1999)

Question: Do we agree with his statement?

Theoretical Background

Definition

Non-Bank Financial Institution (NBFI) are institutions other than banks that offer financial services (FFIEC: 2012).

Services Offered by NBFI

Main services offered by Non-Bank Financial Institutions are:

• 1.      Payments

Some financial institutions provide payments services by issuing claims that have the capacity to be used in settling transactions.

• 2.      Liquidity/credit

Several NBFIs enhance the ability to generate asset’s full market value that can be realized once the decision to sell that asset has been made. An example can be taken from pawn shop.

• 3.      Divisibility

NBFIs break up large denomination and aggregate small denomination. An asset can be traded in small denominations. An example can be taken from mutual funds.

• 4.      Store of value

This service focused on the extent to which an asset provides a reliable store of purchasing power over time. This is related with saving preferences. Saving money in NBFIs in the current year, customers expect to receive a sum of money in the future with the same or higher future purchasing power compared to the current purchasing power.

• 5.      Information

NBFIs support society by process information and assess the risks.

• 6.      Risk pooling

NBFIs offer lower risk to investors.

Many NBFIs provide services that are also provided by banks, that is why the distincition between both types are not crystal clear. However, NBFIs and banks have distinctive characteristic. NBFIs are usually possessed by conglomerates (as the case in Korea which will be described further in the next section), while banks are usually possessed by state or government. Several resources also mentioned that banks are allowed to take demand deposits, while non-bank financial institutions are not (Sufian: 2006, World Bank: 2005)

World-wide Cases                                                                                 

UNITED STATES

During 1990-1991, United States faced another recession. Recession is argued to be a natural part of US business cycle which consists of peak, recovery and expansion (Kamery: 2004). Recession during this period was due to the natural response of expansion (Dunnan and Pack: 1991). During the expansion, economy goes pretty well that triggers the intention of consumers and corporations to borrow fund. Due to the rising demand of borrowings, the interest rates rises. During the expansion period, the rising demand also causes the rise in prices for goods and services, especially houses. These conditions lead to the decreasing demand of borrowings and plummeting spending. The outcomes from too high expansion causes the reveral of the expansion itself. Since the contraction in economy lasted long enough, the economy could be labeled a recession (Kamery: 2004).

The detailed explanations about the conditions causing the recession are depicted in the following figure:

(Source: Mankiw and Ball: 2010)

Recessions such as US recession during 1990-1991 gave severe impacts for financial instituions, especially banks. Banks loses revenue because a recession reduces the demand for loans. Firm get bankrupt and te loan defaults rises. These problems trigger fear of the bank in lending the customers as well (Mankiw and Ball: 2010). 

There are several argument stating that the existence of non-bank financial institutions has helped United States to avoid more severe recession in 1990-1991. When American banks stopped lending during the recession period, the value of real estate collateral also collapse. However, US capital markets were able to substitute for the loss of US banks. Recently developed mortgage-backed securities market kept residential mortgage credit flowing, which would have contracted severely in prior years (Greenspan: 1999). It was even argued that US could have faced more worse recession if the situation is bank based rather than market based (the market is concentrating on banks only, with little and immaterial amount of NBFIs).

Mild recession in US in 1991 is much less sever that the long-lasting problems in Japan and most East Asia countries whose financial system is bank-based. Banks as dominant source of funding in Japan did not possess sufficient power to aver the credit crunch. However, there are no statement that bank-based countries had the same story as Japan. Continental Europe, such as Germany had different story. Most Continental Europe countries were able to escape from the turmoil in the beginning of 1990s because they design proper regulations for banks and other financial institutions.

KOREA: the Financial Sector Liberalization

Gradual liberalization for domestic financial sector has been started in the early 1980s in Korea. As the entry into commercial banking was liberalized, entry barriers for non-bank financial institutions were also lowered. This condition triggered excessive establishment of new financial institutions. However, this condition was also not accompanied by a proper set of supervisions and regulations from the government. Korea system regulated that commercial banks there are under the direct authority of the Bank of Korea’s Office of Banking Supervision while non-bank financial institutions are under Ministry of Finance and Economy. Weak supervision for NBFIs by the MOFE in that era has created opportunities for regulatory arbitrage and lead NBFIs to risky practices.

One critical problem related with Non-Bank Financial Institutions is the rapid expansion of virtually unregulated merchant banks into area generally dominated by banks. The population of NBFI in korea during that era was rather significant, accounting for approximately 30% of financial system assets. These institutions consisted of three main types which are investment institutions, savings institutions and insurance companies. Investment insitutions such as merchant banks, investment trust companies and securities companies play most important role since they possess the largest segment in terms of assets.

Most of investments trust companies were owned by chaebol groups (conglomerates). The regulation indicated that merchant banks were supposed to be supervised by the MOFE. However, supervision was actually minimal. There were not regulations concerning the assets classifications, capital, even the standard practices such as consolidated accounting and market value accounting. Since these merchant banks were related to the chaebol groups, they were used by the chaebol groups to provide funds for them. This condition non only reduced the transparency and market dicipline in raising funds from the public, but also increase the leverage of the corporate sector.

(Source: IMF Working Paper The Korean Financial Crisis of 1997- A Strategy of Financial Sector: 1999 and Carmichael and Pomerleano: 2002)

DISCUSSIONS

Supporting Arguments

The opinion of Alan Greenspan (1999) suggesting that multiple source of finance help to protect economies against systemic problems affecting financial markets are also supported by several evidence and facts. Davis (2001) provides evidence showing that the existence of active securities markets alongside banks is indeed beneficial to the stability of corporate financing, both during cyclical downturns and during financial crisis.

By providing additional and alternative financial services, NBFIs improve general system-wide access to finance. They also help to facilitate longer-term investments and financing, which is often a challenge in the early stages of bank-oriented financial sector development. The growth of contractual/collective savings institutions such as insurance companies, pension funds, and mutual funds widens the range of products available for people and companies with resources to invest. These institutions also provide competition for bank deposits, thereby mobilizing long-term funds necessary for the development of equity and corporate debt markets, municipal bond markets, infrastructure finance, mortgage bond markets, leasing, factoring and venture capital (World Bank: 2006).

Collective savings institutions also allow for better risk management, while helping to reduce the potential for systemic risk through the aggregation of resources, allocation of risk to those more willing to bear it, and application of portfolio management techniques that spread risk across diversified parts of the financial system.

There are several points that highlight the importance of NOBFIs: (Carmichael and Pomerleano: 2002)

• 1.      NBFIs complement banks by providing services that are not well-suited to banks.

• 2.      NBFIs provide competition for banks in the provision of financial services

• 3.      NBFIs specialize in particular sector and target particular group that enable them to enjoy advantages arising from specialization.

The role of Non-Bank Financial Statements in Indonesia

Based on World Bank (2006), up to the current decade, financial institutions in Indonesia are dominated by non-bank financial institutions. NBFIs in Indonesia are much smaller than those in several other large developing countries and in many countries of the East Asia region. In line with the economy-wide shift towards longer term development agendas and emerging development priorities, strengthening NBFIs is now an urgent policy.

Indonesia needs the long-term domestic resources that can be mobilized by NBFIs ,these can be used to finance productive investments, especially infrastructure. This provides a window of opportunity for much needed reforms. While this is an excellent start, more challenges lie ahead on the path to comprehensive reform and strengthening of NBFIs. While each sub-sector has its own specific issues, there are also some common problems across sub-sectors.

Based on the arguments stated previously, I support the statement of Alan Greenspan that non-bank financial institutions are need as back up facilities.

However, learning from the history in Korea, these non-bank financial institutions must be accompanied by proper regulations so that those financial institutions follow good corporate governance.

REFERENCES

Carmichael, Jeffrey, and Michael Pomerleano. Development and Regulation of Non-Bank Financial Institutions. World Bank Publications, 2002, 12.

FFIEC (Federal Financial Institutions Examination Council Bank Secrecy Act/Anti-Money Laundering), 2012, as downloaded from http://www.ffiec.gov/bsa_aml infobase/pages_manual/olm_091.htm.

Feng, W. 2007. The Disinctive Characteristics of Life Insurance Operation. Presentation. As donwloaded from http://www.e-chinalife.com/IRchannel/files/China% 20Life%20Corporate% 20Day%20Presentations-4.pdf

Kamery, R.H. 2004. A Brief Review of the Recession of 1990-1991. Proceedings of the Academy of Legal, Ethical and Regulatory Issues. As downloaded from http: //www.sbaer.uca.edu/research/allied/2004_maui/legal_ethical_regulatory_issues/14.pdf.

Greenspan, A. 1999. Remarks by Chairman Alan Greenspan: Do Efficient Financial Markets Mitigate Financial Crises? As downloaded from:  http:// www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm.

Sufian, F. 2006. The Efficiency of Non-Bank Financial Institutions: Empirical Evidence from Malaysia. International Research Journal of Finance and Economics Issue 6 (2006). As downloaded from: http://www.eurojournals.com/irjfe%206%2 0fadzlan.pdf.

World Bank. 2006. Unlocking Indonesia’s Domestic Financial Resources: The Role of Non-Bank Institutions. As downloaded from:

Note: this material is partially taken from my last assignment on Bank and Other Financial Institutions class.