The accounting standard setters may be prepared to look at fresh ideas to ease the burdens on lessees from having to recognize large numbers of small operating lease contracts on the balance sheet.
This was the message from Patrina Buchanan, technical principal for the leasing project at the International Accounting Standards Board (IASB), in the first interview in a series of Lease Accounting Interviews 2013, which are produced by Asset Finance International in conjunction with International Decision Systems, and chaired by Alan Leesmith FCA, FCT, International Director of IAA Advisory.
Speaking for the joint standard setting bodies – IASB and the US Financial Accounting Standards Board (FASB) – Buchanan said: “The Boards are very aware of the large volume of low value equipment leases that will be affected. The proposed exemption for short term leases [i.e. those which cannot be continued beyond 12 months] should help, though that will not take out all the areas of concern.”
“Most Board members would be prepared to consider meaningful and reliable ways to remove ‘non-core’ assets from the capitalization rule, but the question is how this could be done. For example, would a bank’s buildings be considered non-core? Any view of that might depend on the nature and scale of the bank’s business. Yet if anyone could suggest a method for identifying and defining non-core assets, the Boards would be very happy to receive those suggestions.”
Buchanan stressed that in any event the new lease accounting requirements would be qualified by the “materiality” condition common to all the rules in international financial reporting standards (IFRS) and US GAAP. For newly capitalized operating leases, this would work in the same way as for capitalizing property, plant and equipment (PPE) owned by the reporting entity, or finance leases which are capitalized as PPE assets under existing rules.
She said: “In the ‘Basis for Conclusions’ section of our Exposure Draft (ED), we make clear that if a company treats PPE assets as material where the value of a single asset exceeds (say) €1,000, and its auditors agree that this complies with the PPE accounting rule, then the same materiality threshold would apply to the capital value of a lease contract under the new rules.”
Costs and benefits
Although many critics have called for the Boards to undertake additional cost/ benefit analysis on the proposed rules, Buchanan stressed that balancing costs against benefits was the principle underlying all of the Boards’ deliberations on new standards.
She added: “We are very conscious of the costs for lessees; and compared with the original ED in 2010 the Boards have agreed a number of changes intended to ease the burdens. Lessees will already need to be tracking all their operating leases because of the disclosure rules in notes to the accounts under existing standards, although capitalization will of course add extra steps such as the application of discount rates.”
“We shall be doing fieldwork in depth with a number of lessees during the comment period to make sure that our current proposals are workable.”
Buchanan was firm on the financial reporting benefits of full capitalization by lessees. She commented: “There are several sectors where operating leases add up to very significant financial numbers, and users of accounts need to have a picture of the commitments involved. In both retailing and the airline industry, operating lease values can exceed the total market capitalization of some companies. They can be very high too in other transport sectors, in oil and gas, telecoms, construction and elsewhere.”
Buchanan did not accept the argument that lessees’ unsecured creditors could be misled as a result of “right of use” assets appearing on their balance sheets to which such creditors would not have recourse in the event of insolvency. She said: “Accounting rules are predicated on valuing a business as a going concern, so outstanding lease contracts are relevant to future cash flows. If the rules were to be focused on the insolvency basis it would not just be in leasing where accounts would look very different. Assets subject to secured loans such as mortgages would also have to come out of the picture.”
Although a senior representative of Moody’s has recently expressed criticism of the ED, Buchanan reported much more positive feedback from corporate analysts in general through the Boards’ targeted outreach since the ED was issued. “We have had numerous meetings with investment analysts over the past six weeks. All of the credit analysts have been supportive of our proposals”, she said.
Income statement rules
Buchanan also defended the proposed split between equipment and real estate leases for the purpose of reporting lessees’ expense in the profit and loss account. These would require almost all equipment leases to be expensed on a front loaded basis as with finance leases under existing rules, whereas most property leases (though coming on to the balance sheet) would be expensed on a straight line basis like current operating leases.
She explained: “Originally we proposed a single model, but in response to concerns raised about that it was decided to go for a split model reflecting the economics of different types of lease transactions. There is a real difference between (say) a three-year car lease where the lessee will be consuming much of the value of the asset so it is appropriate to account for amortization, and a lease of retail property for the same period where the asset is likely to be worth as much or more to the lessor at the end of the lease compared with its starting value.”
“At one stage we considered a variation of a single model that would have allowed for these differences, but we concluded that it would be too complex for lessees to operate.”