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Accounting: Revealing hidden commitments

06 June 2016

Accounting: Revealing hidden commitments - read more

Companies must now recognise lease commitments on their balance sheet

Leasing is big business. The IASB estimates that listed companies around the world have $3.3 trillion of lease commitments. However, a significant reporting change will soon hit many companies’ balance sheets.

Earlier this year, the IASB issued IFRS16, its new reporting standard on leasing. The IASB expects its reforms will affect almost 50% of companies using IFRS or adopting similar changes in US GAAP.

During his time as the former IASB Chairman, Sir David Tweedie was explicit: ‘One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.’ The airline business was particularly highlighted by Sir David because, for many companies, a sizeable proportion of their aircraft are not reported on their balance sheets because they are typically operated on short-term leases.

Although Sir David has now retired – his life ambition is finally set to be fulfilled. The new IASB’s leasing reforms overturn the lease reporting requirements that have existed for over 30 years under international and UK national standards.

Crucially, under the former leasing rules in IAS17, the IASB points out that over 85% of lease commitments failed to be recognised in a lessee company’s balance sheet. The new accounting rules address this exclusion by bringing all types of leases onto the balance sheet of lessees.

Current framework

Under the former rules in IAS17, a company that leases an asset has to classify and report the transaction as either a finance or operating lease. A finance lease is a lease agreement that ‘transfers substantially’ all the risks and rewards of an asset from the lessor to the lessee. In other words, the lessee will use, maintain and repair the asset just as it would if the asset had been legally owned.

There are a number of specialist tests that have to be made to decide whether all the ‘risks and rewards’ of an asset have been transferred. A key test is based on discounting the future lease rentals. If the value of the minimum lease contractual payments amount to ‘at least substantially all’ of the fair value of the asset, then it is a finance lease.

In other words, it is a long-term lease agreement for most or for all of the life of the asset. If a lease does not meet the criteria for being a finance lease, it is classified as an operating lease.

From a reporting perspective, the difference in the reporting of these two types of leases is stark. Currently, an asset acquired under a finance lease will be recognised as an asset in the lessee’s balance sheet. In addition, the lessee will also recognise the future contractual lease rentals as a liability.

Even though the lessee does not legally own the asset it is treated, in effect, as if it did. This accounting treatment is largely based on the concept of ‘substance over form’ – where lessees account for the practical reality of a transaction rather than its legal technicalities.

In addition, by default, any other leases failing these tests were accounted for as operating leases by lessees. Operating lease rentals were then merely treated as an expense, without recognising the underlying assets and liabilities.

New rules

The new standard, IFRS16, is based on a single lease accounting model for lessees who will now normally be required to recognise the assets and liabilities of all types of leases in their balance sheets.

The only exemption will be for lease terms of 12 months or less, or where assets have an insignificantly ‘low value’. In other words, by the IFRS16 deadline adoption in 2019, the current difference in accounting treatment between the vast majority of finance and operating leases for lessees will be removed.

Under the new rules, lessees will measure the ‘right-of-use’ of the leased asset in its balance sheet under the cost model. This asset will then be subject to depreciation – as with other non-current assets.

However, the rules do permit property, plant and equipment to be revalued; and to use fair values for investment properties. Lease liabilities will then still be discounted at the interest rate implicit in the lease agreement.

Lessors, which are typically leasing finance companies, also still need to account for leases. However, they would largely continue to follow the former IASB rules and will continue to classify leases as either finance or operating in their own financial statements.

Balance sheet structure

Although many companies will be affected by the reforms, the IASB points out that retailers, airlines and hoteliers will be particularly affected because they are often heavy users of leases. However, it is not just a significant increase in the amount of assets in the balance sheet that will be prominent for many lessees.

For some companies, the leasing changes could significantly alter the structure of their balance sheet. So much so that analysts say Tesco’s total net debt commitments will approximately double to nearly £18 billion as a result of capitalising all types of leases and the resulting lease liabilities. However, the increase in Tesco’s lease liabilities will be largely matched by a corresponding increase in assets when all leases are capitalised in future years.

International Airlines Group

The impact of IFRS16 will even affect companies within the same group differently. International Airlines Group, the holding company that now combines British Airways and Iberia, is typical of the industry’s reliance placed on leased assets. However, there is a difference between how BA and Iberia currently use operating leases.

BA has 284 aircraft – of which 80% are either owned or held under finance leases; with the remaining 20% of its fleet being held ‘off-balance sheet’ as operating leases. In its latest financial statements in 2015, BA reports total outstanding operating lease commitments of £645 million for its aircraft and over £2 billion in commitments for its property leases.

In contrast, Iberia, the Spanish airline has substantially fewer aircraft than BA but with two-thirds of its total aircraft fleet (of 98 aircraft) being held under operating leases. The majority of Iberia’s other remaining aircraft are held under finance leases and are not owned outright.

These finance lease commitments amount to €506 million in its balance sheet but are considerably overshadowed by its future operating leases commitments of over €1.5 billion.

The new leasing reforms will affect Iberia’s reporting of aircraft with its high proportion of operating leases far more extensively than BA. At the moment, neither BA nor Iberia has provided any indication of the effect of the changes on their balance sheet – BA merely states it is ‘currently assessing the impact of the new standard.’

Base numbers

Capitalising all types of leases will also change the base numbers used to determine a lessee’s accounting ratios. The reforms can affect asset and liability balance sheet ratios such as asset turnover and various gearing indicators.

On the income statement side, profit performance indicators may also be changed. For example, the reforms will often give a higher reported operating profit and as a result will impact on earnings indicators such as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) − which in future will exclude the lease interest component of the calculation.

There may also be problems with some debt covenants, where lenders have imposed limits and conditions based on accounting ratios and indicators.

The changes could trigger government tax reforms of leases and even deter some companies from using leases. However, although some of the reported accounting numbers may be altered by the changes, the total net cashflows of companies will remain the same.

Concerns

Some lessee companies are concerned about the costs and complexity of capitalising their operating leases.

Hans Hoogervorst, IASB Chair, admits that there will be additional costs involved for companies implementing the new leasing rules and that he did not expect the standard ‘to be met with enthusiasm’. But he believes the advantages will outweigh the costs involved and the changes would ‘provide management with better insight’ into lease liabilities.

However, some analysts believe that there could be scope for lessees to attempt to reclassify some aspects of operating leases as service contracts to retain the assets off-balance sheet. Indeed, the leasing reforms centre on identifying whether a lease even exists.

The new definition of a lease highlights the existence of control of the asset. This control occurs where the customer has the right to direct the asset’s use and to substantially obtain the economic benefits of the asset.

However, a customer will not obtain this right-of-use to a specific asset if a supplier has a contractual right to substitute or change the asset − in which case, there would be no capitalisation of the asset. In future, if the terms of some agreements are carefully constructed, it may be possible to design a contract for the supply of services rather than having a leasing agreement.

The IASB’s new reporting rules will undoubtedly improve transparency and understanding of many companies’ balance sheets. Currently, many companies leasing assets through operating leases have significant contractual liabilities – which are currently off-balance sheet. By bringing these leases on-balance sheet a clearer portrait of the company’s liabilities can more easily obtained.

As the IASB recognises, implementing these reporting changes are costly in terms of modifying reporting systems and in staff training and time.

Although not all companies agree with the changes, the IASB hopes the benefits will outweigh the costs. At least Sir David will now be a happy flyer − in future his plane will almost certainly be shown in the airline’s balance sheet.

John Sittle is a Senior Lecturer at the University of Essex

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