Impact of new lease accounting proposals

By Stewart Cumberbatch, audit director at Deloitte’s Financial Services Practice

The long-awaited revised Exposure Draft (ED) on lease accounting was published by the IASB on 16 May 2013 and addresses a number of the problems identified by respondents following the initial Exposure Draft published in 2010.

For lessees, the new proposals bring all leases on balance sheet, with the exception of short term leases and a few scope exclusions.

The IASB believes this enhances the comparability and transparency of financial statements and resolves certain perceived shortcomings of the current approach that fails to recognise certain rights and obligations that meet the definition of assets and liabilities.

They argue that this has resulted in a significant number of leases being recognised “off balance sheet” and banks and ratings agencies, in particular, making adjustments to company balance sheets for this hidden leveraging.

What are the proposals for lessees?

Lessees would record the right to use the leased asset (ROU asset) and a lease liability representing the contractual obligation to pay rentals over the term of the lease, initially measured as the present value of the lease payments.

A separate expense would be recognised for the amortisation of the ROU asset and the interest cost on the lease liability for leases where the lessee consumes more than an insignificant portion of the underlying asset (Type A leases), and a single straight-line expense would be recognised where only an insignificant portion of the underlying asset is consumed by the lessee (Type B leases).

Generally, leases of cars and commercial vehicles (as well as other items of plant and equipment) will be classified as Type A leases while leases of real estate would be classified as Type B leases.

In response to the need for reduced cost and complexity there is an exemption for short term leases, allowing the use of existing operating lease accounting. Short term leases would be those that have a maximum possible term of 12 months, including a presumption that extension options will be exercised.

Contracts with non-lease components, such as the hiring of vehicles with a maintenance service, would see payments allocated based on the relative observable purchase price of the individual components. If lessees are unable to obtain observable purchase prices they would account for all the payments as a lease, rather than a lease and a separate service.

What are the proposals for lessors?

For Type A leases, lessors would derecognise the leased asset and recognise a receivable for future lease payments and a residual asset.

The residual asset represents the lessor’s retained interest in the underlying asset and is commonly referred to as the residual value in the leasing industry, although the amount in the balance sheet should be net of any unearned profit.

Subsequently, the lessor would unwind the discount on both the receivable and the residual asset, reassessing the lease payments and discount rate if required. The accounting would be more complex if the lease included variable lease payments.

For Type B leases, lessors would retain the whole underlying asset on their balance sheet and recognise lease payments as lease income over the lease term on a straight-line basis or another basis if more representative of the pattern in which income is earned from the underlying asset.

Lessee impacts

The accounting will be more complex for lessees, with leases previously treated as an operating expense now coming on balance sheet.

For type B leases, the replacement of the current straight line operating lease expense with an interest expense on an amortised cost basis (front end loaded) and a typically straight-line amortisation of the ROU asset will result in a an accelerated recognition of lease costs when compared to the existing approach.

This, coupled with the changes in the recognition of assets and liabilities has the potential for key financial ratios to be affected such as debt to equity, return on assets, EBITDA and operating margins. As a result debt covenants may be affected and may need to be renegotiated.

The recognition of all lease arrangements in the balance sheet may affect lessee attitudes to owning as opposed to leasing items of property, plant and equipment, which may in turn drive a response to the leasing industry in terms of new products such as short term leases that are able to preserve some of the existing benefits of operating leases.

For example, short term leases for a year or less with no renewal option would not be captured by the new accounting rules and would still qualify for off balance sheet accounting treatment.

Such a lease would, however, change the economics of the lease transaction and result in increased risk to the lessor, in addition to increasing the administrative burden of lease renewals, which would undoubtedly lead to increased lease costs.

For financial institutions, concerns that right of use assets would be intangibles (potentially resulting in a 100% deduction from regulatory capital) may, to an extent, be appeased by the revised ED which allows for separate presentation on the balance sheet or inclusion in the line item where the underlying asset would be presented.

Lessor impacts

The balance sheet impact for lessors is likely to be of less significance than for lessees, although estimating the value of residual assets for type A leases and accounting for variable lease payments may prove onerous and require considerable judgement.

The most significant impacts for lessors are likely to be the resource required to evaluate existing operating lease contracts (with certain transitional reliefs being provided for finance leases) and to develop processes to capture the required information on an on-going basis.

Furthermore, the new Standard may result in a need for many companies to upgrade or replace their existing accounting systems and therefore any companies currently considering systems replacement projects may be well advised to consider the impact of the proposals in order to avoid costly re-work at a future date.

What next?

Given the importance of leasing to the UK economy, industry lobbying to date has focused on the need for the proposals to be straightforward for small businesses to implement and not to detract from leasing as a simple and cost effective product.

The proposals would see an increased reporting burden on lessees in particular, and lessors will have a key role to play in assisting their customers implement the changes. The provision of new fleet reports showing the indicative accounting over the lease term or the effect of modifications to lease contracts could be provided although this would likely require investment in underlying IT systems.

Regardless of the accounting, companies will continue to lease vehicles as the majority of the existing benefits will remain, in that leasing is generally a more flexible and cost effective way to run a fleet than ownership. It limits residual value risk and provides the option of an integrated fleet management service.

Overall, the proposals could have a huge impact on business and affect many key performance indicators. The question for constituents will be whether they agree with the IASB’s perspective on the benefits they believe these proposals would bring, and whether those benefits are significant enough to justify the associated costs.