Lease agreement reform will show the true state of the balance sheet

As Sir David Tweedie enters the final lap of his premiership at the International Accounting Standards Board (IASB) there is nothing higher up his to-do list than the reform of lease accounting. An IASB insider informs me that it is his pet project. The output he seeks can be expressed simply enough. According to an old joke of his, he wants to fly on an aeroplane that actually appears on the balance sheet of the airline.

And he may well get his desire, but probably not before he is using all those air miles in retirement rather than on active duty.

It is an idea who’s time has finally come. While the leasing industry hates the proposals with a passion that borders on irrational, finance directors and their colleagues know that analysts and users of financial information deserve an accounting standard that gives them the information they seek.

Many companies already give out information to analysts, credit rating agencies and banks to take away the guesswork, but it is not a consistent effort. According to research by PricewaterhouseCoopers (PwC) and the Rotterdam School of Management, a frequently used rule of thumb is to multiply the annual lease expense by seven to work out the lease liability, on the grounds that the average remaining lease term for many corporates is seven years. Speak to FDs with leased assets and they will tell you this short cut does not accurately reflect the effects of changes in foreign exchange rates, interest rates or the average remaining lease term.

The proposed accounting standard on leases would significantly alter companies’ balance sheets – with the appearance of more assets and liabilities – and the profit and loss account where lower profits may feed through, at least at first, because of front-end loading of expenses. The PwC/Rotterdam research, which looked at 3,000 companies worldwide, suggests that the reported interest-bearing debt of companies would rise on average by an eye-watering 58 percent. But while debt may shoot up, so will earnings for many companies and this proposal will also increase volatility. The important point that FDs need to be looking at now is how these changes would impact on covenant tests on other forms of borrowings, as these may need to be renegotiated in order to prevent technical breaches.

The problem for FDs is not on the right-of-use approach that the exposure draft advocates, but on how the lease assets and liabilities should be measured. The critics of this exposure draft are right in one sense that it is a complex standard.

Some blame that on the US-influenced rules-based approach. But you could equally blame a desire for the proposals to be consistent with decisions on other projects, especially revenue recognition. Under the proposals, lessees will recognise a “right to use asset” and an “obligation to make lease payments”, initially measured at the present value of the expected outcome of the lease payments discounted at the lessee’s incre­mental borrowing rate. Thereafter, the “right to use asset” will be depreciated and liability will be amortised using an effective interest method. The original estimates of expected outcome for some leases will have to be re-estimated as circumstances change. This is not simple to do, or explain. FDs need to get a grip soon.

The joint exposure draft on leasing is open to comment until 15 December, so send your thoughts in. Arguments over lease accounting have been around for decades with the leasing industry claiming any change would destroy asset finance as we know it. That is fanciful stuff. The real argument here is the old one between accounting substance and legal form. Every reader of accounts needs account­ants to be in charge of what goes into accounting information, not lawyers or financiers.

Some elements of the proposals may change, especially on lessor accounting, but the main thrust of the proposals looks certain to become a standard. At that point the biggest off-balance sheet loophole will finally have been plugged.