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August 17, 2010

Lease accounting draft met with concerns

A draft lease accounting standard released by the International Accounting Standards Board and the US Financial Accounting Standards Board would bring all leases on balance sheet – introducing more transparency to the rights and obligations arising from leases.

The standard would also introduce more complexity and lead to a substantial rise in company debts. One industry group has gone as far as warning it could hamper the UK’s economic recovery.

Existing accounting rules under both IFRS and US GAAP depend on the classification of a lease. Classification as an operating lease results in the lessee not recording any assets or liabilities on the balance sheet.

The draft standard would require lessees to book assets and liabilities for all leases; off balance sheet accounting would no longer be allowed.

The proposal uses a right of use approach to lease accounting for both lessees and lessors. This means the liability for payments arising under the lease contract and the right to use the underlying asset would be brought onto the lessee’s balance sheet.

Long overdue

Deloitte Global IFRS leader Veronica Poole said the draft standard is a “long overdue reality check” that will introduce greater transparency.

“The downside to the standards, if implemented, will be significantly increased liabilities on the typical corporate balance sheet, which could have a knock-on effect on key performance indicators,” Poole added.

“The result could be lower asset turnover ratios, lower return on capital, and an increase in debt-to-equity ratios, which could affect borrowing capacity or compliance with loan covenants.” 

PwC UK director John Williamson suggested that the boards’ efforts to align the leasing standard with other IFRS, particularly in revenue recognition, has led to a level of complexity in the measurement and re-measurement of leased assets and obligations.

Williamson warned the impact of this accounting will significantly increase the level of gearing of businesses that currently use substantial amounts of operating leases in their business.

“It will front end load the total expense for depreciation and interest in the early periods of the lease, in much the same way as if lessees had financed these assets with debt,” he explained.

Contentious issues

The lessor accounting proposals are even more contentious, Williamson added. The boards initially struggled to agree on a preferred model for lessor accounting and compromised on a hybrid version where some leases will be accounted for under a performance obligation approach and others under a de-recognition model.

“The reaction from the leasing industry has understandably been very negative as neither model seems to be an improvement on existing accounting and it s noticeably different from the economic models the industry uses for pricing,” Williamson said.

“The proposals also bear the hallmarks of being rushed as the decision to include lessor accounting in the ED was only re-instated in early 2009.”

KPMG Global IFRS leasing standards leader Wolfgang Laubach said applying the new lease models will be a challenge.

“We had hoped the leasing exposure draft would reduce complexity and avoid the current situation of multiple approaches that rely on rules to distinguish different types of leases,” Laubach said.

“It’s disappointing this hasn’t happened.  We still have the rules, just in a different form.” 

Industry reaction

The UK Finance and Leasing Association (FLA) warned that the propose standard could make asset finance harder to obtain, which would hamper the UK’s economic recovery as it depends on strong business investment.

The FLA said bringing operating leases on balance sheet would mean businesses would have to prepare theoretical estimates of the value and cost of the lease and include these on their balance sheets. Julian Rose, Head of Asset Finance at the Finance and Leasing Association said the proposals involve “taking real numbers and replacing them with a mish-mash of accountants’ assumptions, estimates and adjustments”.

“To propose imposing these arcane and costly new regulations on UK businesses so soon after the recession makes no sense,” he said.

Rose called on the IASB to carry out a proper cost-benefit assessment and to drastically simplify its proposals.

The lease accounting exposure draft was developed following a discussion paper, released in March 2009, which attracted more than 300 comment letters.

The exposure draft is open for comment until 15 December.

 

Related articles

Round table preview: Debate heats up on lease accounting

Proposed standard may increase reporting complexity: Leaseurope

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