Lease accounting and IFRS

Accounting for leases is expected to change fundamentally if the current proposals in the Exposure Draft on Leases see the light of the day.

Both the International Accounting Standards Board and the US Financial Accounting Standards Board released the Exposure Draft on Leases in August 2010 and the comment period ended on 15 December, 2010.

Since then many expert groups have expressed concern over the proposals. To receive more comments on it, both the boards have decided to re-expose the leasing project.

A recent report issued by Chang & Adams Consulting warns that the current proposals could have an adverse impact on US companies.

Significant departure

So what is this gloom and doom all about? Probably, the most fundamental change is the departure from the operating-lease model, which exists in the generally accepted accounting standards.

While operating leases are usually a shorter term and show a straight-line rental income or expense, depending on whether an entity is the lessor or lessee, finance leases (referred to as capital leases under US GAAP) are usually for a longer term, when compared to the life of the asset, and are treated as if the assets are owned by the lessee.

A significant portion of premises and equipment rental agreements in the corporate sector are operating leases, which results in the lessee simply accounting for the rental expense.

The Exposure Draft proposes that almost all leases should be treated like a finance lease, and therefore need to be recorded on the balance sheet. Thus this would lead to a significant reclassification on the balance sheets. Hence, companies having leased premises or equipment would be expected to have higher liabilities on their balance sheets because they would recognise an obligation towards such leases with a corresponding right-of-use asset.

This is likely to also increase the debt-to-equity ratios of such companies, and therefore impact their ability to raise finance. The respondents to the Exposure Draft also envisage that the proposals are too complex to implement.

Poor estimates

On the other hand, the boards argue that the present lease accounting standards have problems. Both US Generally Accepted Accounting Principles or GAAP and International Financial Reporting Standards have two lease categories, finance and operating leases.

Since lessees, under operating leases, simply account for the lease payments as expense over the term of the lease, investors have to estimate the effect of operating leases on financial leverage and earnings.

According to the boards, these adjustments are often estimates without robust support. Therefore, to enhance the quality of reporting and prevent the need for such arbitrary adjustments by investors, the proposed model is more consistent.

Something to cheer about is that leases with terms less than 12 months are categorised as short-term and are excluded from the scope of such asset and liability recognition.

However, the caution is that structuring of such leases for shorter terms appended with options to extend or renew may not meet the definition of a short-term lease.

Further, the boards have also tentatively agreed to exclude lessors and owners of investment properties from the applicability of the proposal.

The boards have agreed to reissue the Exposure Draft in the second quarter of 2012. It seems certain that the rule makers would have to consider carefully the concerns raised by the industry and businesses before the final standard is released for adoption.

(The author is a Partner, Price Waterhouse.)

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