Leases on the Loose
Special report on leases concludes that the distinction between operating leases and finance leases that is required by present standards is arbitrary and unsatisfactory. The main deficiency being that they do not provide for the recognition in lessees’ balance sheets of material assets and liabilities arising from operating leases.
Date: 1996 and published by the G4+1 group of international standard setters (being Australia, Canada, New Zealand, the UK and the USA).
Sir David Tweedie, a previous Chairman of the International Accounting Standards Board, often quipped that “One of my great ambitions is to fly in an aircraft that is on an airline’s balance sheet”. Because they very rarely have been.
Twenty years on and the revised international standard on leases (IFRS16 – Leases) was finally published in January 2016, largely to deal with these long recognised deficiencies.
There has been some delay but perhaps Sir David can now achieve his ambition!
Why is this so important?
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. This type of agreement is prevalent in some business sectors such as retail where many high street retailers will rent property from landlords. Under current accounting treatment, 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.
The current treatment of this classification of leases is arbitrary. A finance lease is treated as a debt or borrowing on the balance sheet and the leased asset appears under assets and is depreciated. Interest payments on the finance lease are reflected in the profit and loss as an interest expense.
By contrast if a lease is treated as an operating lease, it only appears on the financial statements as a lease or rental charge on the profit and loss statement and it does not appear on the balance sheet. The business has the use of an asset, but the asset and the debt taken on to acquire it are not reflected in the balance sheet.
Thus the accounting treatment of a lease as an operating lease flatters the return on capital employed (by reducing the capital employed in the business) and reducing the apparent gearing (debt to equity) ratio.
This is significant as the IASB has estimated that listed companies using IFRS or US GAAP had almost US$3 trillion of off balance sheet lease commitments in 2014.
Analysts, who are generally smart people, were aware of these anomalies, so they often adjusted balance sheets to allow for this – typically by multiplying the annual rental payment by a factor of, say, eight and adding the resulting total to both the asset and liability sides of the balance sheet. However wise they may be, we can be certain that this rough and ready approach will not give the right answer! It’s far more complicated and the holder of the detailed information necessary to carry out the calculation is the company leasing the assets. From January 2019 companies will have to do the more detailed calculations and capitalise the vast majority of the assets and liabilities associated with leases.
It is also significant because many ratios get distorted according to whether assets are leased or not. In this respect, W. H. Smith has been on the side of the angels for a long while, and transparently discloses the impact of operating leases on its return on capital employed (ROCE). Below is an excerpt from their latest preliminary statement (for the period ended 31st August 2015).
So other companies with leases will soon have to incorporate similar adjustments with sometimes as dramatic a change to ratios (this may also force changes to the covenants in loan agreements—covenants are usually part of bank loan agreements and impose certain conditions on the borrower to which they must adhere).
From 2019, if your organisation is accounting for leases, as a lessee, under International Financial Reporting Standards (IFRS) then the distinction between operating leases and finance leases will be no more. Note this has been written carefully as changes are not yet being fed through to UK GAAP under Financial Reporting Standard (FRS) 102, and the distinction is still relevant to lessor accounting under IFRS. So as of this moment, private UK companies (who will be reporting under FRS 102) will not be applying this standard.
In addition, the US FASB and IASB have not fully converged on this standard and it’s likely that the distinction will affect how lease rentals are charged to the income statement under the soon to be published US standard.
Well it was never going to be that easy – even with a twenty year head of steam!
The key proposals are that, applying the new single lessee accounting model, a lessee is required to recognise:
- a) Assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is low value; and
- b) Depreciation of lease assets separately from interest on lease liabilities in the income statement.
As well as altering the size and shape of the balance sheet, there will be related changes to the income statement. Other things been equal, the new accounting treatment for leases will increase operating profit or earnings before interest and tax (EBIT) because the new depreciation charge on the asset is likely to be less than the previous operating lease charge or rental. And earnings before interest, tax, depreciation and amortisation (EBITDA) will increase as more of the expense is treated as depreciation which is ‘below the line’. In addition, although the total charge over the life of the lease with be the same under the old and new regimes it is likely that the new charge will be ‘frontloaded’ by the finance cost element. If a company with significant operating leases has not already done so, then it should start modelling the changes and discussing the impact with lenders, investors and other relevant stakeholders.
It might seem odd to some that an asset and liability will be recognised for, say, a two year lease of a 100 year life asset where it would seem obvious that the risks and rewards of the asset rest substantially with the lessor. This is because the new definition of a lease focuses on control as opposed to the risks and rewards of ownership. All leases create a “right of use asset” and associated liability. What the standard requires is the recognition of the “right of use” of the asset for the two year period, which at initial recognition, is likely to be the present value of the two years of future lease payments.
To qualify for exemption, a short term lease of 12 month or less period must not contain purchase options and the substance of a series of one year leases or similar structure would need to be assessed. The low value leases are likely to relate to items such as a personal computers or items of office furniture and equipment. There is no monetary threshold in the standard but the IASB have indicated a level or around $5,000.
To learn more about these issues, BPP offers relevant courses including:
Accounting and Financial Analysis 1, Financial Analysis CPD courses for non accountants can be found here