PwC IFRS blog

Lease accounting: “There could be blood all over the streets”!

A few weeks have passed since the release of the IASB’s leasing discussion paper

. Thankfully, Sir David Tweedie’s stark warning back in 2004 ("There could be blood all over the streets") has not transpired, although there is already disquiet in certain quarters, such as LeaseEurope. Certainly there is nothing new in the proposals from the joint IASB/FASB leasing project; to a large extent it builds upon the work undertaken since 1996 by the G4+1 group of standard setters, which culminated in their 1999/2000 paper entitled ‘G4+1 Special Report, Leases: Implementation of a new approach’. Almost a decade has passed, so it is high time that the project was taken to its next stage. However, the new proposals could significantly change lease accounting for all lessees.

The main proposal is to eliminate operating lease accounting. Lessees would treat all leases in a manner similar to the way finance leases are accounted for today. What does this mean? Well, some believe the proposed accounting model would have the greatest impact on companies that lease significant high-value items such as real estate, ships and of course aircraft, which have been used as the ‘poster child’ for advocating the capitalisation of all leases for years. It was with these large value leases in mind that Sir David Tweedie was quoted as saying that "every company with a big asset is going to erupt". But spare a thought for the companies that lease large volumes of relatively small value assets − for example, a company that leases a large fleet of company cars. There is no scope exemption proposed for these companies, so they also would be required to put all such assets on the balance sheet.

Apart from the practicalities of doing this, which I will touch on more below, does it matter that these assets are now going to be capitalised? At first glance you may think ‘yes’. Certainly there are countless academic research papers on the subject that highlight not only the significant increase in balance sheet measures, such as gearing or leverage ratios, but also profit measures, such as profit margin and return on assets. However, many investors have acknowledged that they already make adjustments to the published figures of many of these companies to reflect the use of operating leases, in order to improve comparability between companies with different financing and asset ownership structures. If this practice is prevalent among investors, perhaps the main effect will be to provide investors with more precise values to the liability, rather than leaving them to make up their own estimates.

The second key proposal will require the lessee to reassess lease terms, contingent rentals, residual value guarantees and the corresponding lease obligation at each reporting date. The Boards argue that this will provide more meaningful information. But it will also require significant incremental effort compared to the current model, where lease accounting is set at inception and revisited only if there is a modification or extension of the lease. Consider again the company that leases a fleet of cars for its workforce. Requiring reassessment of each individual lease in every reporting period will most certainly result in additional time and cost being devoted to this form of financing and could influence the buy or rent decisions.

But perhaps what is most apparent from the discussion paper, given the passage of time since the G4+1 paper, is what has not been addressed rather than what has. The Boards have not formulated a preliminary view of lessor accounting; the ‘other side of the equation’. This has some merit, given its high degree of interaction with their ongoing revenue recognition project, but it has left questions about how companies that act as both lessor and lessee should deal with their transactions. And this is not all; the Boards are also yet to address sale and leaseback transactions, the timing of initial recognition, lease incentives and a list of other potentially significant issues.

We are expecting a converged standard on this project by 2011. Because of the significance of the changes proposed and their expected impact, I encourage readers to consider the implications of the proposals on their businesses and to take the opportunity to express their views to the IASB.

I would also be very interested in your views on the proposals either by commenting here or by email.

Simplified IFRS - tailor-made for non-listed entities

In the next few months, the IASB is due to release its final standard for SMEs (or ‘private entities’ or ‘non-publically accountable entities’ – all these names have been used by the Board during the development of the standard). It was once widely considered an impossible task to deliver a simpler set of standards attractive to private entities, and it has been a long time coming.

Small and medium-sized entities have been struggling with the question of whether or not to adopt IFRS for many years. In most cases, the answer has been ‘no’. This is because IFRS was developed for listed entities and did not fit the needs of non-listed entities’ (SMEs) or the users of their financial statements. Also, due to its complexity, the application of IFRS can be quite costly, and not all SMEs are prepared to pay large amounts for the conversion of their financial statements to IFRS, nor do they have sufficient knowledge to do the job in-house.  There are, however, some notable exceptions to this approach, such as Australia where IFRS applies in full to all companies, listed or otherwise.

But many SMEs have a clear need for standardised accounting rules and would prefer to adopt internationally harmonised rules rather than locally developed standards. Within Europe alone there are some 55 local accounting standards. Just imagine the challenge of compiling the consolidated accounts of a UK-based group with subsidiaries in Germany, Italy, Switzerland, the Netherlands, France and Bulgaria. All countries have their own set of reporting standards, all based on the 4th and 7th EU Directives, but all with different flavours and starting points. Much time and money could be saved if companies adopted one harmonised reporting standard. The differences between the new standard and many local accounting standards (in particular in the EU) have reduced, which seems likely to ease the adoption process.

The stand-alone standard is now almost final, following a process of preparation, deliberation, working group meetings and field tests. SMEs all over the world are invited to consider adopting it. However, the IASB has advised jurisdictions not to rush to make the standard mandatory in 2009; it recommends allowing time for companies and auditors to familiarise themselves with the contents and to plan their transition process.

The IASB hopes that ‘IFRS for Private Entities’ or ‘Simplified IFRS’ – the final title is to be announced soon – will offer increased comparability, more convenient cross-border acquisitions, improved relationships with overseas customers and improved negotiations with finance providers. It will be interesting to watch its take-up to see whether ‘small IFRS’ can achieve the same global acceptance as its bigger brother.

As always I'd be delighted to recieve feedback, either by commenting here or by email.