Sweeping lease accounting changes announced
Corporate balance sheets are set to be transformed by the addition of billions in additional liabilities and assets, under the new international lease accounting standard just published.
IFRS 16 Leases represents one of the most revolutionary changes in financial reporting for many years. Drafted by the International Accounting Standards Board (IASB), the new standard is aimed at increasing transparency and providing a more realistic view of the economic impact of leasing contracts.
Leased assets typically include aircraft, rolling stock, heavy plant and machinery, and buildings. The IASB estimates that listed companies using IFRS Standards or US GAAP are estimated to have around US $3.3trn of lease commitments, of which more than 85 per cent do not appear on their balance sheets.
That is because, under accounting rules dating back 30 years, leases to date have been categorised as either ‘finance leases’ (which are reported on the balance sheet) or ‘operating leases’ (which are disclosed only in the notes to the financial statements).
This distinction made it difficult for investors to compare companies, the IASB said. It also meant that investors and others had to estimate the effects of a company’s off balance sheet lease obligations, which in practice often led to overestimating the liabilities arising from those obligations.
All leases to be reported
IFRS 16 aims to solve this problem by requiring all leases to be reported on a company’s balance sheet as assets and liabilities.
IFRS 16 is effective from 1 January, 2019, although early application is permitted for companies that also apply IFRS 15 Revenue from Contracts with Customers.
Hans Hoogervorst, IASB Chairman, said: “These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations.
Identifying all the relevant transactions is challenging enough, not least the boundary between what is now considered a ‘lease’ and a ‘service’.
“The new Standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.”
The release of IFRS 16 is the culmination of a long and hotly debated process, during which the IASB worked closely with the US Financial Accounting Standards Board (FASB).
Although the two boards say they “are aligned on the central issue of bringing leases onto balance sheets”, their respective solutions differ in important details.
After feedback from the consultation process, the IASB has conceded some cost-saving measures, including exemption for ‘small-ticket’ items and short-term leases for periods shorter than 12 months.
Veronica Poole, global IFRS leader and UK head of accounting, Deloitte, said: “The real challenges start now and the volume of work in the lead up to a 2019 implementation must not be underestimated.
“Identifying all the relevant transactions is challenging enough, not least the boundary between what is now considered a ‘lease’ and a ‘service’. What is in and what is out will result in a series of difficult judgments.”
Brian O’Donovan, UK partner in KPMG’s International Standards Group, said: “The key change will be the increase in transparency and comparability. For the first time, analysts will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.”
He added: “No-one wants to see accounting drive business behaviours – the tail shouldn’t wag the dog.
“But if accounting consequences are in the mix when a company is considering a deal, then the mix will change. For example, this standard essentially kills sale-and-leaseback as an off balance sheet financing proposition.”
Mr O’Donovan also warned that the full impact of the new standard will only be seen when other bodies, such as tax authorities and financial services regulators, determine how they will respond to the accounting changes.
ICAS will publish its formal response soon.