The Bruce Column — Leasing: Take two

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16 May 2013

The revised proposals on lease accounting have at last been published. Robert Bruce, our resident, regular columnist looks at the issues.

Re-exposing the revised proposals on lease accounting is a significant point in the long debate over whether all leases should be recorded on balance sheet. The arguments still turn on two differing views. The first view is that leasing is a form of hidden leveraging that should not be allowed to remain off balance sheet. This is a big issue both conceptually and economically. It is estimated that some $1.5trillion would be brought onto the balance sheets of US companies alone. The second view is whether the economics of leasing are really not that clear cut and current operating leases are similar to simple service, or executory-type, contracts.

The IASB argue that all leases convey a right of use of the leased asset and that right and a matching liability should be recorded on balance sheet. The IASB’s original lease exposure draft published in August 2010 (the “2010 ED”) proposed that lessees should apply a single model, the ‘right-of-use model’, to all leases within the scope of the proposals. In the 2010 ED, the lease asset would have been amortised generally on a straight-line basis, whilst the liability was amortised using the effective interest rate method. In the income statement, the 2010 ED would have resulted in an accelerated pattern of expense recognition for all leases. However, many constituents indicated that the expense recognition pattern proposed in the 2010 ED did not reflect the economics for all types of leases. The 2013 proposals attempt to respond to these criticisms, introducing a new dividing line, which is likely to generate significant debate given that one of the project’s original objectives was to remove the existing “bright-line” between operating and finance leases. The IASB is now proposing two types of leases for expense recognition purposes in an attempt to respond to concerns expressed about the 2010 ED. This revised model results in what looks like operating lease accounting for property leases, while most equipment leases will be subject to the same front-loaded expense recognition pattern that generated concern in response to the 2010 ED. To some these are practical steps, to others they are a blurring of conceptual coherence. Some of the other concerns which respondents to the original exposure draft raised have been addressed like those around variable payments. But even so, what will be important will be the effects.

There would be significant changes to the financial reporting of leases which may have a significant knock-on effect on some key KPIs such as gearing ratios, debt-covenants and anything which is an earnings-related measure. On top of that there may well be a need to capture additional data about leases in reporting systems and also there may be considerable deferred tax implications to book when the eventual standard is first applied. The debate, of course, will not just be about whether the proposals on the table are sufficiently practicable, and not only about their conceptual merits, and not just the impact on the KPIs, but critically: ‘Is this better than what we have today?’

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