FINANCIAL REPORTING AND IR

...but does it represent an improvement, and at what cost?

After almost 10 years of drafting, consulting, and debating, this quarter the IASB and the FASB finally released new standards on accounting for leases. The new lease standards replace existing IFRS and U.S. GAAP guidance and will have a fundamental impact on the accounting for leases. Although the standards are not effective until 2019, companies need to begin assessing and preparing for the impact on their financial statements and considering how these changes may impact business decisions.

Existing lease accounting models have been criticized by some for failing to provide a faithful representation of leasing transactions. The lease project looked to address these critiques, with a goal of reducing complexity and eliminating arbitrary accounting distinctions for transactions that are economically similar. Simultaneously, the project sought to eliminate differences between IFRS and U.S. GAAP by converging to a single, global standard. Although not all objectives were met, several key areas have been addressed.

Lessee accounting

The Boards have implemented a major shake-up for lessee accounting. Under the previous lease accounting rules, leases classified as operating leases stayed off-balance sheet. Under the new standards, all leases are coming on-balance sheet for lessees.

Under the new standards, a ‘right-of-use’ asset and corresponding lease liability will be recognized for all leases. Instead of simply recognizing lease expense over the lease term of an operating lease, all leases will effectively be treated as a purchase of the asset on a financed basis, grossing up both assets and liabilities.

Sadly, after almost 10 years of negotiation, standard setters could not agree and full convergence between IFRS and U.S. GAAP was, unfortunately, not attained. While they are consistent in requiring all leases to be ‘on-balance sheet’, the rules differ in terms of the accounting models used:

• The U.S. standard contains a dual model for lessee accounting that provides separate measurement guidance for operating leases versus finance leases, which will permit operating leases to continue to recognize rental income/expense straight-line in the income statement.
• The IFRS model adopted a single model for all lessee accounting, which treats all leases as financing arrangements in both the balance sheet and income statement.

Lessor accounting

Changes to the lessor accounting model will be less significant, with both standards retaining the key aspects of the current dual accounting models, although there are new disclosure requirements. Changes on the lessor side may also come from the potential asymmetry when lessors, such as franchisors, are in back-to-back leases that have two separate accounting models.

Lease definition

One area where the Boards were able to agree is on the definition of a lease and what constitutes an arrangement that is a lease versus a service contract. The determination has changed from existing standards to focus on whether a customer controls the underlying asset during the term of the lease while obtaining the benefit of the output of the asset. Convergence in this area is welcome given that all arrangements considered to be leases will now consistently be on-balance sheet for lessees, under both IFRS and U.S. GAAP.

Benefits – at a cost

The Boards recognized the significant costs of implementation, but concluded the benefits of the new leases standards will outweigh implementation costs, and financial statement users will receive better information. More information will be disclosed in the financial statement notes for both lessees and lessors to provide a more complete picture of their leasing activities and exposure (e.g. asset risk and, for lessors, credit risk).

The standards did introduce an exception for short-term leases that would see leases with lease terms less than 12 months remaining off-balance sheet. The IASB also agreed to exclude low value items from the balance sheet model. Both standards also provide transition relief, in the form of an option to grandfather existing determinations around what is a lease versus a service contract. Further transition relief provided by the IASB includes the ability to recognize a cumulative adjustment to opening retained earnings rather than adjusting comparatives.

Key impacts of new standards

Companies will be required to identify all lease agreements using the new definition of a lease and have available all relevant lease data – including the details of lease renewals and purchase options. Systems changes may, in some cases, be required to provide a complete inventory of all lease information needed for transition.

The impact of the new standards will be felt across industry sectors. Companies leasing big-ticket equipment, such as airlines and other transportation companies, will see significant changes on their balance sheets, with large increases in reported assets and liabilities. Similarly, major property lessees, such as retailers, will see a large increase in assets and liabilities, as property leases generally would be on-balance sheet for lessees.

Key financial metrics will likely be affected by the grossed up recognition of leased assets and lease liabilities, and by changes in the pattern and presentation of lease income and expenses. In addition to the impact on key financial ratios, compliance with debt covenants and employee compensation arrangements may also be impacted.

Companies may, in the future, seek to structure lease transactions in different ways. The current focus on whether a lease is an operating lease (off-balance sheet) or a finance lease (on-balance sheet) will become irrelevant. Companies will reconsider their traditional buy versus lease decision criteria, and in some cases may no longer find leasing advantageous. The attractiveness of sale-leaseback transactions as a form of financing may also be impacted, as such transactions will now also be on-balance sheet for the seller-lessee.

Investors and other stakeholders will want to understand the impact of the new standards on a company’s business, although many analysts already make adjustments for the effects of off-balance sheet lease accounting.

For many companies, preparing for the far-reaching impacts of these changes will take considerable effort. Companies need to start assessing the possible impacts now and begin planning for transition, as identifying areas of change and communicating impacts early will be important. Investor relations professionals are well advised to keep connected to their finance teams in order to understand how the adoption of the new standards will impact both the business and reported results.

Andy Brown, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada