New leases standard – getting close

The IASB has issued Leases: Practical Implications of the new Leases Standard, a project update.

Written plainly and set out clearly, it’s likely to be a useful document for those who know something big is coming, but haven’t to this point immersed themselves in understanding exactly what that is. It’s not really mandatory reading from a decision-critical perspective – the final standard isn’t due until later in 2015, with another few years until the effective date. But it’ll at least help interested parties in considering whether they know generally where this is going, and whether it’s likely to mean anything to them.

The basic summary is this:

  • “In essence for all leases, the IASB model requires a lessee to:
  • (a) recognize lease assets and liabilities on the balance sheet, initially measured at the present value of unavoidable lease payments;
  • (b) recognize amortization of lease assets and interest on lease liabilities over the lease term;
  • and
  • (c) separate the total amount of cash paid into a principal portion (presented within financing activities) and interest (presented within either operating or financing activities).”

The biggest concern of preparers has likely been that this broad concept will require a lot of additional work for little material result. The IASB addresses the larger part of this concern by not requiring lessees to recognize assets and liabilities for leases of 12 months or less (short-term leases), or for leases of small assets (such as laptops and office furniture). Also, among other things, lease liabilities for purposes of the standard only include fixed payments and optional payments that the lessee is reasonably certain to make – they exclude variable lease payments linked to use or sales.

Obviously, the new model will increase the carrying value of assets and liabilities. The net impact on equity will most often be a decrease: “The carrying amount of lease assets will typically reduce more quickly than the carrying amount of lease liabilities, (reducing) reported equity compared to today for lessees with material off balance sheet leases. This is similar to the effect on reported equity that arises today from financing the purchase of an asset, either through an on balance sheet lease or a loan.”

As for the impact on profit or loss: “For lessees that currently have material off balance sheet leases, the IASB model will result in higher profit before interest (e.g. operating profit) compared to the amounts reported today… This is because, under the IASB model, a lessee will present the implicit interest in former off balance sheet lease payments as part of finance costs whereas, today, the entire off balance sheet lease expense is included as part of operating costs.” However, “lessees typically hold a portfolio of leases, which generally has the effect of neutralising any effect on profit or loss compared to existing requirements. For example, if a lessee’s lease portfolio is evenly distributed (i.e. the same number of leases start and end during a period and the lessee enters into new leases similar to those that end), then the overall effect of the IAS model on profit or loss would be neutral.” Of course, if the composition of the portfolio isn’t so evenly distributed, then there would be an effect on profit or loss; however, the IASB’s research indicates that the lease portfolio would have to change quite significantly for this effect to be noticeable.

The model will reduce operating cash outflows, by treating part of what’s currently an operating lease outflow as a principal outflow; total cash flows will be unchanged.

In terms of cost and complexity: “the IASB expects the main costs to arise from gathering that data on a timely basis so that lease assets and liabilities are recognized at each reporting date. The data required is similar to that needed to provide note disclosures for existing off balance sheet leases with the exception of needing discount rates to apply the Boards’ new requirements.” Matters such as borrowing costs and debt covenants will be affected, but “the IASB’s outreach indicates that most sophisticated users of financial statements (including credit rating agencies and lenders) already estimate the effect of off balance sheet leases on leverage, particularly when an entity has a significant amount of off balance sheet leases.” The Canadian experience of making the transition to IFRS supports the general sense that measurement changes driven by changes in accounting standards won’t usually cause an insurmountable difficulty with contractual or similar matters.

Some may look at all of this and ask then, is it worth it? That is, if sophisticated users already have methodologies for collapsing the differences between finance and operating leases, and if many of the key measures in the statements won’t change significantly, then how damaging could it be to go on as we are? Perhaps the change in approach was more urgently needed in the past, when differences between capital and operating leases were often dramatically artificial (like many of us, I expect, I recall discussions and memoranda focused entirely on ensuring – pre-IFRS – that the assessment of a particular lease came in a hair below the “90% test,” thus allowing operating lease treatment) and when other disclosures and technology didn’t provide as much assistance as they do now in looking through that. But even if things aren’t as bad as they were, that doesn’t mean they can’t be made better: the IASB’s earlier project update summed up how, even if investors and analysts currently try to adjust for the effects of the lease model, it’s difficult for them to do that reliably and consistently. Once we get through the transition, it’s hard to see too many people looking back at our current approach with any kind of principled nostalgia….

The opinions expressed are solely those of the author

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