While the IASB and the FASB (the boards) consider changes to the original lease accounting proposals , a number of companies are already starting to prepare, spurred on by the significance of the proposed changes.
Improving lease accounting has been a long-term goal of the boards as a criticism of the existing lease standards is that lessees do not recognise all lease obligations on their balance sheets, based on arbitrary distinctions between operating and finance leases.
The resulting exposure drafts (ED) issued in August 2010 led to a record level of feedback. Many respondents said that the proposed approach was overly complex, costly and in some cases, inconsistent with the economics of the underlying transactions.
In response, the Boards have scaled back and simplified the original proposals but have not removed the underlying premise of recognition of all leases on balance sheet.
The proposed model is a fundamental change in lease accounting and will result in complex accounting changes that may bear minimal resemblance to the underlying commercial arrangements for many companies.
For any companies with operating lease arrangements, the new model will result in a gross-up of the balance sheet and a deterioration of the debt-to-equity ratio and return on assets compared with current accounting. The timing of expense recognition would accelerate and be re-characterised as interest and amortisation expense rather than today’s rental expense. This would improve financial metrics such as EBITDA but may require new reconciliations to explain underlying ‘operating results’ as these current profit measures will no longer include lease charges.
Lessees may want to reassess their lease-versus-buy strategy as well as understand other commercial impacts, for example, debt covenant ratios.
Early buy-in fr om key stakeholders is important to maintain confidence in a business’s reported results. In addition, fundamental internal change may be required to existing business processes and systems.
Under current proposals, companies will be required to recognise on balance sheet a right-of-use asset and lease liability for any ‘unique, identifiable’ physical assets wh ere a right of use is conveyed under a lease arrangement. This definition includes not only significant property leases, but also leases for equipment such as IT, photocopiers, machinery and vehicles, which may be numerous.
Compliance with the proposals will require companies to collate new, and possibly significant volumes, of data in relation to lease arrangements. Identification of the population and nature of arrangements that may be in scope is a crucial starting point to an impact assessment and determination of data collation requirements.
In addition, existing software and spreadsheets would most likely no longer be sufficient to maintain the more complex models required for calculation of financial reporting requirements. The revised model will not only add new assets and liabilities to the balance sheet but will also require periodic reassessment of these and documentation of judgments applied.
The magnitude of changes to certain companies from a financial statements’ preparation and business perspective will require establishment of cross-functional project teams to ensure a smooth transition.
A final standard is likely to come in 2012 following re-exposure in autumn 2011. This may signal adoption for 31 December 2015 year ends with requirement for comparatives for 2014 and an opening balance sheet date of 1 January 2014. Commercial lease arrangements, however, tend to be negotiated months or years in advance, so early planning is essential to avoid unwanted surprises and costly missteps.
These are not simple changes and will be costly to implement. I empathise with a number of clients who have challenged whether IAS 17 is sufficiently broken to warrant the effort required and knock-on business impact.
Partner at Ernst & Young, leads the Financial Accounting Advisory Services team across the UK & Irelands
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