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.

Comments

[Enrique Rosado CPA Lima Peru]

About accounting for lessees on DP,s yet, the terms of this proposal are contrary to the proposed changes to Revenue Recognition. We have to consider, as well, that the assets do not belong to the lessees until they exercise their right to buy at the end of it(buy out terms). How would the lessor treat this leases then, because legally the assets are theirs yet, regardless of any transfer of control or "temporary" use. The Committee and the Board have to consider also the tax implication in different economical jurisdictions, where for example, a declining balance depreciation method is mandatory for tax purposes. This could create a non deductible terminal loss for the company if the option to purchases in some cases is not exercised by the lessees in economical environments where legislation do not treat this type of leases in the same way as a leasehold improvement where a straight line is permitted and the useful life of the improvement equals the term of the lease.
They have to take into account that this method of depreciation for Capital Cost Allowances(tax deductible depreciation expense) exceeds several times in years the useful life of the asset., reason why it could produce a terminal loss if the accounting for lessees changes as the Board and committees intend.
As you mentioned in your article, the extra cost of controlling according to the proposed method will outweigh its convenience. In large companies will require a considerably increase of asset management hours.

[Enrique Rosado CPA Lima Peru]

Comment about definitions:

A company needs not to pay income tax to operate (going concern)
Second: Income tax is an imposition from a selfdeclared partner, that is, the government.
Third: Income tax is based on the taxable profit, therefore it is more in between a preferred stock payment(liability) and a common stock dividend(equity)
Fourth: When there is a loss, there is no Income Tax. The loss is carried forward to offset profits for a certain limit of
years to follow. So it is proven that an enterprise does not need Income Taxes to function, whether with a gain or a loss.
No matter how we look at it, an expense is a cost needed DURING the Operation of Business Activities in order to produce Income, and Income Tax do not fit this definition.

CONCLUSION: Taking into account the above, hence, Income tax is not an expense, and IFRS, IAS,s , and us as accountants should stop calling it an expense, for it is only a form of distribution of profit to a self-declared and imposed partner, called Government.

[accountant in Bromsgrove]

There maybe different opinions with this matter.Taxes are always visible in every business whether small or big.The main thing explain here is how it will serve as an advantage to everyone.