Lease accounting - some important questions to consider right now

If you are involved in a business where to generate income you have to lease assets, an Exposure Draft (ED) recently issued by the International Accounting Standards Board (IASB) will most likely significantly change what you currently report in your financial statements. This is expected to apply to June 2013 financial statements retrospectively for all leases in existence from that date. 

The key change that is being made to current practice is that every lease obligation, (a liability), together with the accompanying “right to use” the leased equipment (an asset) will now end up being reflected in your balance sheet.

Neither the length of the lease agreement nor the type of asset involved can influence the accounting outcome. Everything from real estate, boats, planes, trains, trucks and cars through to photocopiers, computing equipment and even the mobile phone you use at work, will captured by the ED. 

In light of this, there are eight “killer questions” that we believe every CFO should consider both for current leases and before entering into any future contractual arrangements to lease assets.

If you find yourself answering “yes” to any of the questions  noted below, we encourage you to seek out a copy of the ED and talk to your Grant Thornton adviser  to learn more about the forthcoming changes to lease accounting.  Having read and considered the ED, if you have concerns about the outcomes that the proposed standard will generate, we encourage you to make comments to the Australian Accounting Standards Board (AASB) before 12 November 2010.

1. Are you subject to financial covenants?
   If you lease assets, and you are currently close to breaking debt to equity ratios, the forthcoming proposals will almost certainly make your situation worse.  This is because all lease commitments will be deemed to be a financial liability, and so will need to be recognised in the statement of financial position.  The ED completely removes the distinction between operating and finance leases so leverage and capital ratios will deteriorate as soon as the proposed standard comes into effect.
   
   
2. Do you have a track record of renewing your lease arrangements after the initial term has expired?
   If this is a likely outcome and it’s probable that most of the lease arrangements you enter into will extend into a second or third term, then this must be taken into consideration when determining the lease liability that you must reflect in your balance sheet.  The ED requires one to take into account the lease period that is most likely happening; not solely the initial lease term. As one might expect, the longer you lease an asset, the greater the lease liability that will need to be recognised at inception.
   
   
3. Does the lease agreement contain any contingent rental conditions, term option penalties or residual value guarantees?
   To ensure that the liability (and of course the corresponding “right-to-use” asset) is not understated in the balance sheet, the IASB has introduced some additional elements that need to be taken into consideration.  The IASB’s goal in including these factors into the determination of the liability is to reflect the economic substance of the arrangement – taking into account all, not just some, of the cash flows associated with the leasing arrangement.  Hence contingent rentals, term option penalties and residual guarantees will all need to be taken explicitly into consideration.
   
   
4. Having entered into a leasing contract are you likely to change the period over which you will lease the asset?
   If this is a circumstance likely to happen, then the ED requires you to recalculate your obligations under the leasing arrangement and adjust your financial statements accordingly.  For some this will not be a huge imposition, but if you are a large and complex organisation, with hundreds of lease contacts, this has the potential to be a time consuming task.
   
   
5. Are your leasing arrangements currently being tracked via spreadsheets?
   While for some organisations there is still most definitely a place to track leasing commitments through the use of spreadsheets, for others this will not be an appropriate solution because the number of variables that will need to be assessed and monitored under the proposed standard are extensive.  While it can be argued that there is a time and a place for everything, when this ED becomes a standard retrospective application will almost certainly be required. Now is the time to evaluate the robustness of the controls and systems that support your lease accounting processes.  In many instances an upgrade may be needed.
   
   
6. Do your deferred tax calculations include leasing arrangements?
   It is highly likely that the legislation surrounding the tax treatment of operating leases will not change, so when the lease commitments are reflected in company balance sheets, many new temporary differences, will be created.  Given that temporary differences (as defined in IAS 12 Income Taxes) multiplied by the applicable tax rate generates the deferred tax liability or a deferred tax asset that will need to be reflected in the financial statements, preparers of fincial statements would do well not to underestimate the amount of work associated with accounting for this component of their financial statements.
   
   
7. Are your staff performance incentives based on operating cash flows or EBITDA basis?
   This ED will no longer result in straight line recognition of rent expense in income statements.  Lessees rent expenses will end up being front-loaded because of the interaction of effective interest being used to reduce the recognised financial liability coupled with the depreciation of the “right to use” asset.  Because interest and deprecation will “replace” rent expenses, EBITDA and operating cash flows will increase when the proposed standard come into effect. Assessing the impact of these accounting changes is strongly recommended so that remuneration protocols are appropriately aligned with financial reporting expectations.
   
   
8. Are you a lessor as well as a lessee?
   Prior to the release of the ED the IASB released a Discussion Paper that failed to consider lessor accounting.  This ED addressed this oversight and now considers lessor accounting.  It proposes two accounting models for lessors, each to be used in different circumstances depending on the terms of the lease and its effect.  Both the accounting models described in the ED modify current practice (i.e. straight line profit over the period of the lease arrangement), so considerably more work will need to be done “behind the scenes” to determine the amount of future profit that can be recognised when preparing forecasts and projections.

Although eight important questions have been noted above, like most financial reporting standards, the devil is in the detail and many more questions could be put up for consideration. 

Our recommendation is to consider the future implications of this ED now rather than when it is enacted because it has the potential to significantly reshape future financial statements.

Thanks to Grant Thornton New Zealand’s National Technical Director, Mark Hucklesby, who is a member of Grant Thornton’s Taskforce that is preparing Grant Thornton’s global submission to the International Accounting Standards Board. Mark can be contacted at: mark.hucklesby@nz.gt.com

For further information please contact either Mark, your usual Grant Thornton advisor, or the author of this article:

Author, Keith Reilly, October 2010

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