Leasing: a tale of two balance sheets
Sir David Tweedie delivered an oft-quoted speech in Australia in August 2002, in which he told the attending luminaries that they had never flown on an aircraft that was on the airline’s balance sheet. It is somewhat serendipitous that, on the eighth anniversary of that speech (give or take a couple of days for poetic licence), the IASB and US FASB issued an exposure draft of proposals that might put those aircraft on two balance sheets instead.
Leasing is big business. According to the World Leasing Yearbook 2010, the annual value of leases in 2008 was some $640 billion. Look around you; there is a good chance you are sitting in a leased building, having driven to work in a leased car (or been carried there on board a leased train) and are reading this article on a leased computer. Leasing is pervasive, so it is inevitable that the new proposals will attract attention.
The headline is the removal of the distinction between a finance lease and an operating lease such that all leases will be ‘on-balance sheet’. Specifically, the Boards propose a ‘right-of-use’ model, which will require a lessee to recognise an asset representing its right to use the leased item for the lease term, and a corresponding liability at present value for the obligation to pay rentals. Subsequently, the asset and liability will be measured at amortised cost. Rent expense will be therefore be replaced by a combination of depreciation and interest, which will be front-end loaded compared to the current expense profile, but which will result in an increase in EBITDA.
However, the proposals go further than merely removing operating leases from the accounting glossary. Arrangements currently accounted for as finance leases will change too. Under existing standards, an option to extend a lease is considered part of the lease term only if the lessee is ‘reasonably certain’ to exercise it. Under the Boards’ proposals, however, lessees will be required to include term extensions where ‘more likely than not’ to be exercised. This is a lower hurdle, so assumed lease terms will increase, as will assets and liabilities as a consequence.
Furthermore, under existing standards, contingent rents − such as those that vary with a property index or levels of sales from a retail store − are recognised as expenses in the period incurred. Under the Boards’ proposals, however, lessees will be required to estimate the obligation to pay rentals, including the contingent element.
The new proposals will result in a significant change for almost all lessees, both in terms of what is recognised on the balance sheet and also in terms of how it is measured.
Research completed by PwC and the Rotterdam School of Management has quantified the minimal impact of the proposed model on lessees. Based on the operating lease disclosures in financial statements of some 3,000 companies worldwide, the study concludes that the reported interest-bearing debt of these companies will increase by an average of 58%. In addition, the companies in the sample will see an average increase in EBITDA of 18%, as rent expense will be replaced by depreciation and interest expense.
The research also shows that the impact on financial ratios differs significantly by industry. For retail companies, for example, the reported debt balances are expected to increase by an average of 213%.
While it is lessee accounting that attracts the headlines, the Boards have also tackled lessor accounting. They propose a dual model, which depends on the economic characteristics of the lease. Where the lessor has retained exposure to significant risks or benefits associated with the leased asset, the leased asset will continue to be accounted for; but the lessor will also recognise a lease receivable and a corresponding performance obligation liability. So we have two assets and a liability, which seems rather confusing and certainly adds to complexity, although they will be totalled to a single number on the face of the balance sheet. A consequence of this model, of course, is that aircraft are on everyone’s balance sheet!
In all other cases, lessors will apply the derecognition approach, which effectively treats the transaction as a part disposal of the underlying asset.
In 2002, Sir David Tweedie ‘guaranteed’ that leases would be on-balance sheet within three years. He missed that target, but the current project has momentum, and it seems inevitable that its basic premise (that is, to get all leases on-balance sheet) will reach its conclusion. The Boards currently aim to issue a final standard next summer, but it remains unclear when it will be effective. The Boards are consulting separately on that question, as a number of significant projects are due to conclude around the same time.
I'd be very interested to hear your comments on this ever changing issue.