The existing accounting model for leases has been criticised for failing to meet the needs of users of financial statements. Many users think that operating leases give rise to assets and liabilities that should be recognised in the financial statements of lessees. Consequently, users routinely adjust the recognised amounts in an attempt to recognise those assets and liabilities and reflect the effect of lease contracts in profit or loss. However, the information available to users in the notes to the financial statements is insufficient for them to make reliable adjustments to the recognised amounts.
The existence of two very different accounting models for leases (the finance lease model and the operating lease model) means that similar transactions can be accounted for very differently. This reduces comparability for users. The existing standards provide opportunities to structure transactions so as to achieve a particular lease classification. If the lease is classified as an operating lease, the lessee obtains a source of unrecognised financing that can be difficult for users to understand. In particular, it has proved difficult to define the dividing line between finance leases and operating leases in a principled way. Consequently, the standards use a mixture of subjective judgements and ‘bright-line’ tests that can be difficult to apply.
As a result the International Accounting Standards Board (IASB) has commenced a project with the objective to create common lease accounting requirements to ensure that the assets and liabilities arising from lease contracts are recognized in the statement of financial position. The direction of the leasing project is clear for lessees. The IASB has tentatively settled on a right-of-use model. This requires the lessee to recognize an asset representing its right to use the leased asset and a corresponding liability for its obligation to pay rent. Operating lease accounting under IAS 17, Leases, is eliminated. Lessees account for all leases by creating assets and liabilities in a manner similar to that used for finance leases today.
The current accounting for leases takes an all or nothing approach to recognizing leases on the balance sheet, which results in significantly different accounting for transactions with similar economic substance.
For all leases, the lessee will recognise:
A lessee would not recognise the components of a lease contract separately (such as options to renew, purchase options, contingent rental arrangements or residual value guarantees). Instead, the lessee would recognise:
The lessee's obligation to pay rentals should be measured initially at the present value of the lease payments (including a probability-weighted estimate of contingent rentals) discounted using the lessee's incremental borrowing rate. Subsequent measurement would be on an amortised cost basis.
The lessee's right-of-use asset should be measured initially at cost. Cost equals the present value of the lease payments discounted using the lessee's incremental borrowing rate. The lessee should amortise the right-of-use asset over the shorter of the most likely lease term (which might include renewal periods) and the economic life of the leased item.
Impact on the Airline Industry
The proposed model has the greatest impact on lessees of major capital items, such as real estate, manufacturing equipment, power plants, aircraft and ships. This new lease accounting standard could result in a world of hurt for the balance sheets of airlines. The airline industry stands to incur millions of rands in liabilities if new accounting standards are adopted which aim at bringing expensive lease contracts on to balance sheets. According to the experts the new standards have the potential to undermine confidence in weaker carriers which only own a small portion of their fleets, according to some operators. The changes could expose the weak financial positions of some airlines. Those that will be most impacted will be the weaker airlines who have no ability to borrow cash. The new standards may highlight to the public the financial weakness of these businesses.
At the moment, companies can pick and choose whether leases are held on or off balance sheets by manipulating the technical distinction between finance and operating leases.
Conclusion
The main proposal is to eliminate operating lease accounting. The question arises: 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.
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.
