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Lease accounting changes: What’s it all about?

By / 5 years ago / Features / No Comments

The International Accounting Standards Board (IASB) has published a new set of rules – an ‘accounting standard’ – setting how companies should account for leases in their books.

In this article we try to answer the question; at the most basic level, what is the new IFRS 16 accounting standard all about?

All companies publish two key documents annually: a profit and loss account and a balance sheet. The profit and loss account shows revenues, expenses and the difference between them – profits. The balance sheet shows assets and liabilities and the difference between them – shareholders’ funds (or ‘net worth’).

There are two types of leases; finance leases and operating leases. A finance lease is one where the risks and rewards of ownership are taken by the lessee (the hirer). The key risk we are interested in here is the risk in the residual value of the car – what it will be worth at the end of the contract. If the lessee bears this risk it’s a finance lease and if the lessor (the leasing company) bears this risk it’s an operating lease.

In the 1980s debate raged about the nature of finance leases. Academics and investment companies said that a finance lease was effectively a type of a loan that should be disclosed on the balance sheet as a liability, rather than the company just showing the rentals in the profit and loss account. Leasing companies said this was wrong and that balance sheets should only show the assets that companies actually owned. The leasing industry lost this argument and the accounting rules were changed, putting finance leases onto companies’ balance sheets for the first time.

Finance and operating leases have been treated differently ever since. As well as showing finance leases ‘on balance sheet’, companies also have to disclose details of their operating lease obligations in notes to the accounts.

But the investment companies were still not happy. They pointed out that the distinction between finance leases and operating leases was not particularly helpful to them. They wanted to know what assets were being used in the company, regardless of how these were being financed, so they were manually adjusting companies’ reported results.

There has been another protracted series of discussions lasting nearly a decade, and the academics and investment companies have once again prevailed. The result is a new set of accounting rules called ‘International Financial Reporting Standard 16, Leases’ (IFRS 16), which replaces IAS17. Listed companies, banks and some other ‘public interest’ businesses have to comply with IFRS16 for accounting periods commending on or after 1 January 2019 but many will need to change their systems to comply with the new rules well before that in order to be able to show 2018 comparative figures in their 2019 accounts. The vast majority of businesses won’t be affected unless we see a further change in the rules.

Under the new rules the distinction between finance leases and operating leases disappears. The standard-setters have said that even when a company leases an asset under an operating lease, the lessee still does have an asset; the right to use the asset. It is this which has to be shown on the lessee’s balance sheet (where it will need to be depreciated) and there will be a corresponding liability on the other side of the balance sheet.

Lessees’ profit and loss accounts will have to include depreciation and interest cost on these assets and not the rental charge. As interest cost is always higher in the earlier stages of finance agreements than later on, lessees will now report greater costs in the early years of a new lease than before. Short-term or low value leases are exempt from the new rules.

We will have to wait to see whether the European Commission approves of the use of IFRS16 in Europe, and how (and whether) the tax rules will change following these accounting changes.

As it currently stands, most commentators don’t believe that these changes will have a significant impact on the attractiveness of operating leases (such as contract hire), because the vast majority of companies have chosen operating leases because they are a great form of financing rather than because of any accounting considerations.

Nonetheless, these changes will have a dramatic effect. The IASB believes that affected businesses have US$3.3 trillion of lease commitments, over 85% of which do not appear on their balance sheets.

Professor Colin Tourick – Grant Thornton Professor, University of Buckingham

 

 

Industry reaction: What the IFRS 16 standard means for vehicle leases…

“Bringing leased vehicles onto the balance sheet will not erode the key benefits of leasing. Vehicle leasing continues to grow in popularity and this has very little to do with any balance sheet advantages.

“Its main value comes elsewhere, sheltering companies from the risk of fluctuating vehicle values, providing them with extra flexibility and purchasing power and freeing-up precious working capital that would otherwise have been spent buying an asset.”

Gerry Keaney, chief executive of the British Vehicle Rental and Leasing Association (BVRLA)

“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 judgements.

“The final result should be clearer for both preparers and investors, since a very obvious part of financing will become explicit rather than remain implicit. Ultimately, the new standard will ensure a more accurate outcome that investors will welcome.”

Veronica Poole, global IFRS leader and UK head of accounting at business advisory firm, Deloitte

 

“It is crucial to recognise that the changes only apply to the way the leases are accounted for from a balance sheet perspective. It does not change the operational aspects of the lease arrangement.

“An operational lease will still provide benefits such as the certainty of fixed monthly payments, the removal of capital outlay for ‘heavy use’ assets, and additional services provided by the lessor.”

Matt Dyer, managing director of fleet management and financial services specialist, LeasePlan

 

“Bringing leased vehicles onto the balance sheet will not erode the key benefits of leasing. Vehicle leasing continues to grow in popularity and this has very little to do with any balance sheet advantages.

“Its main value comes elsewhere, sheltering companies from the risk of fluctuating vehicle values, providing them with extra flexibility and purchasing power and freeing-up precious working capital that would otherwise have been spent buying an asset.”

Gerry Keaney, chief executive of the British Vehicle Rental and Leasing Association (BVRLA)

 

“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 judgements.

“The final result should be clearer for both preparers and investors, since a very obvious part of financing will become explicit rather than remain implicit. Ultimately, the new standard will ensure a more accurate outcome that investors will welcome.”

Veronica Poole, global IFRS leader and UK head of accounting at business advisory firm, Deloitte

 

“The new requirements are less complex and less costly to apply than the IASB’s earlier proposals. However, there will still be a compliance cost. For some companies, a key challenge will be gathering the required data. For others, more judgemental issues will dominate – for example, identifying which transactions contain leases.

“Some key impacts cannot yet be quantified; companies won’t have the full picture until other accounting and regulatory bodies have responded. For example, the new accounting could prompt changes in the tax treatment of leases.”

Brian O’Donovan, UK partner for audit, tax, and advisory specialist KPMG’s International Standards Group

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Katie Beck

Katie joined Fleet World in 2012 as an editorial intern, following the completion of an English and American Literature BA from the University of East Anglia. She accepted a full-time position as an editorial assistant at the end of the internship period, and was promoted to the role of features editor in 2014. She works across the magazine and website portfolio, and administrates the social media channels.