Question

What are the results from the proposed changes to lease accounting on operating and capital leases. Identify how the right to use model will impact financial reporting, indicate how companies are likely to manage the change in reporting. What recommendations could be made to CFOs of retailers , service providers, and other businesses that lease several locations or have substantial leases of real estate or other assets. What are the pros and cons of each approach.

Answer 1

Under existing rules, lessees account for lease transactions either as operating or as finance leases, depending on complex rules and tests which, in practice, use ‘bright-lines’ resulting in all or nothing being recognised on balance sheet for sometimes economically similar lease transactions. The impact on a lessee’s financial reporting, asset financing, IT, systems, processes and controls is expected to be substantial. Many companies lease a vast number of big-ticket items, including cars, offices, power plants, retail stores, cell towers and aircraft.

Therefore, lessees will be greatly affected by the new leases standard. The lessors’ accounting largely remains unchanged. However they might see an impact to their business model and lease products due to changes in needs and behaviours.

Lessees

1. The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. These impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions.

2. Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expense relative to the recognition pattern for operating leases today).

3. Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships, and technology – are expected to be greatly affected. The impact for entities with numerous small leases, such as tablets and personal computers, small items of office furniture and telephones might be less as the IASB offers an exemption for low value assets (assets with a value of $5,000 or less when new). Low value assets meeting this exemption do not have to be recognised on the balance sheet.

4. The cost to implement and continue to comply with the new leases standard could be significant for most lessees. Particularly if they do not already have an in-house lease information system.

Lessors

1. Lessees and lessors may need to consider renegotiating or restructuring existing and future leases.

2. Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to be effective (for example, joint ventures and special purpose entities).

3. Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to the changed needs and behaviours from customers which impacts their business model and lease products.

Right to Use Model

The distinction between operating and finance leases is eliminated for lessees, and a new lease asset (representing the right to use the leased item for the lease term) and lease liability (representing the obligation to pay rentals) are recognised for all leases*. Lessees should initially recognise a right-of-use asset and lease liability based on the discounted payments required under the lease, taking into account the lease term as determined under the new standard. Determining the lease term will require judgment which was often not needed before for an operating lease as this did not change the expense recognition. Initial direct costs and restoration costs are also included.