Leasing: changes on the horizon

Back in 2010, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) issued an exposure draft ‘2010 Leases’ which caused an element of outcry among those that report under IFRS.  Indeed, the proposals contained in the exposure draft were of such a radical nature that if they were implemented, other countries reporting under national accounting standards that converge to IFRS could also jump on the bandwagon and change the area of lease accounting to run in conjunction with IFRS.

However, at a meeting in London on 13 June 2012, the IASB and FASB both agreed on a revised method of accounting for leasing arrangements which would include two types of lease transaction, essentially based on the length of time a lease is taken out in comparison to the value of the leased asset.

Current accounting rules

It is prevalent throughout the financial reporting world that when an entity enters into a finance lease, the asset subject to the lease will be capitalised in the balance sheet with a corresponding lease creditor.  Conversely when a client enters into an operating lease, the accounting is more straight forward; payments are charged to the profit and loss account on an arising basis.  This treatment is consistent with the requirements in UK GAAP at SSAP 21 Accounting for Leases and Hire Purchase Contracts, IAS 17 Leases and Topic 840 on leases in US GAAP and is a uniform accounting treatment in many (but not all) countries.

Lease accounting has always been somewhat controversial because of the ability to manipulate lease transactions to achieve a desired outcome (often referred to as ‘off balance sheet finance’).  The IASB’s World Leasing Year Book in 2009 cited an amount of some $760 billion in leases back in 2007 and this figure is likely to be much higher now.  Critics have said that the ways in which lease transactions are currently accounted for mean that many leases do not appear on balance sheets which mislead users.  Not only has this been a problem recently, but it is a problem that has been around even since the introduction of accounting standards governing the ways in which leases are accounted for.

Many entities around the world believe that if they enter into a leasing arrangement with a lessor, there is no requirement to put the asset subjected to the lease on the balance sheet because they have not, in effect, taken out a loan to finance the lease.  The problem with this interpretation is that such entities are looking to the asset’s legal form as opposed to the substance of the arrangement. In a finance lease, the substance of the arrangement is such that an asset has been acquired by the lessee and the lessee has used a leasing arrangement as a means of financing the asset’s acquisition.

The principles contained in IAS 17 (and also the new UK GAAP) are based on the risks and rewards of ownership of an asset.  If the risks and rewards associated with ownership of a leased asset remain with the lessor, then this lease falls to be treated as an operating lease; whereas if the risks and rewards are passed to the lessee, the lease falls to be treated as a finance lease, hence the asset is capitalised on the balance sheet with an associated lease creditor representing the capital element of the future lease obligations payable to the lessor.

Proposals

The original proposals contained in the 2010 exposure draft introduced a ‘right of use’ model which was considered to be a significant change.  Essentially the 2010 exposure draft suggested that all leases, regardless of whether risks and rewards remain with the lessor or pass to the lessee, should be treated as a finance lease, therefore eradicating the operating lease classification.

These proposals came in for a substantial amount of criticism from those entities that use genuine operating leases as a means of financing assets.  Indeed many professional accountants and analysts said that the use of such a model would seriously distort the financial statements, particularly EBITDA.

Had the proposals been given the go-ahead and been enshrined into IFRS, a company would have had to apply the ‘effective interest rate method’ on the liability owed to the lessor.  This means that a company would have an interest charge based on its outstanding liability, so the financial statements would reflect a higher charge in the earlier years, whilst a lower rate of interest would be recognised in the later years, so the expense profile of a lease transaction would essentially be front-loaded in the earlier years of a client’s leasing arrangement.

Other entities were also concerned as to the effect the proposals would have on them if they were to be passed by the IASB and FASB because the revised accounting treatment would result in lower asset turnover ratios, lower return on capital and a detrimental impact on gearing ratios.  For clients that have loan covenants imposed on them by financiers, the proposals were quite worrying as it could mean that covenants may well be breached.

The IASB and FASB tentatively agreed that all leases should be recorded on the balance sheet, but acknowledged the need to consider the ways in which the classification and pattern of expense should be recognised within the income statement (profit and loss account).

Revised approach

On 13 June 2012, the IASB and FASB agreed on an approach for lease accounting in respect of the expense that would be recognised within the income statement.  This would affect companies that report under IFRS (and US GAAP) and the IASB and FASB are planning to issue a joint exposure draft in the fourth quarter of 2012, with a planned version of the revised accounting standard being issued in mid-2013 and a potential implementation date in 2015/2016 (though this has yet to be confirmed).

Under the ‘compromise’, the two boards agreed that some lease contracts would be accounted for under a similar approach to the treatment outlined in the 2010 exposure draft, hence all such leases will be reported on the balance sheet.  This treatment would apply to the vast majority of lease transactions which are entered into for periods of more than one year.

There are some leases which would be accounted for in a similar way to an operating lease (in other words by way of a straight-line expense into the P&L account (income statement)) and this treatment would apply to those leases which represent a relatively small percentage of the life (or value) of the leased asset.  So if a lease transaction is not significant over the life of the asset, the treatment is the same as that of an operating lease.

Expensing leasing payments on a straight-line basis to the P&L account (income statement) for those leases which represent a relatively small percentage of the life/value of the leased asset would eliminate an ‘uneven spread’ because otherwise if such short leases with a relatively small percentage of the life/value of the leased asset were put on balance sheet, this would result in depreciation charges AND interest charge on the liability, hence there would be a higher expense reported in the profit and loss account (income statement) in the early part of a lease transaction.

Conclusion

It is going to be quite difficult for the IASB and FASB to please everyone who enters into lease transactions (particularly operating leases), and indeed there are going to be many disgruntled lessees carefully scrutinising the IASB/FASB’s proposals when their latest exposure draft is published later in 2012.

Category: Accounting and standards