THERE HAVE been nearly two years of consultation relating to the new lease accounting regulations, and rightly so. A 2010 Accountancy Age article states that the changes “will bring an extra £73.7bn in new assets and liabilities onto the balance sheets” of UK companies.
Essentially, the FASB’s first Draft Exposure states that the new model will eliminate off balance sheet accounting, where all assets currently leased under operating leases will be brought onto the balance sheet, removing the distinction between financing and operating leases. The key idea behind this is to give stakeholders a more accurate picture of a company’s finances.
Clearly leases, particularly property leases, are a significant cost to many businesses, and stating them as assets and liabilities will have a profound effect on company accounts and important ratios. Nevertheless, it is believed that 54% of UK companies are not yet aware of the effect the changes will have on their books.
However, businesses intent on their accounts remaining unchanged by the new regulations do have options when it comes to property leases. For example, flexible office renting solutions, such as serviced and managed office solutions are likely to remain as operating costs. Their monthly rolling rental agreements mean their term is less than one year, and so cannot be recognised as an asset or liability. This is in keeping with the growing trend of flexible office solutions becoming increasingly popular as businesses embrace new, more modern ways of working.
So why exactly are parts of UK industry concerned about the changes and how they will manage them? Firstly, debt-to-equity and return on capital ratios will be dramatically affected. Clearly these are the ratios that banks use when setting loan parameters, and businesses that are not prepared could find themselves going through the expensive, and potentially unnecessary process of renegotiating loans. In addition, these are also the ratios that investors put emphasis on when making decisions about a company.
On the other hand, earnings before interest tax and amortisation (EBITA), an analyst favourite, will be flattered because leases will no longer be found as a cost on the profit and loss account, perhaps painting a misleadingly positive picture.
Evidently businesses that have lots of leases will be affected most e.g. retailers, transport companies that lease vehicles and larger businesses that have lots of property commitments. However, some leases will be exempt from the proposals, including leases to explore for or use natural resources, leases of biological assets and leases of investment property measured at fair value.
So how can FD’s deal with the proposed changes? Firstly, nothing has been set in stone yet so it’s important to keep up to date with the proposals, know when the second Draft Exposure will be published and exactly when, or if the new proposals will be implemented.
If your business has debts, you should liaise with your lenders in advance to find out how flexible they are prepared to be if your loan to value ratios artificially change. What is their attitude to the lease accounting changes and how are they intending to deal with them? They should have a good idea by now.
Educating the users of accounts so they understand the changes is also key. Those stakeholders that don’t have accounting knowledge, perhaps those on your board, will most likely get a shock if they have not been forewarned of the reason for dramatic changes in important ratios.
Clearly it will be easier for smaller, private companies to inform necessary parties. However, plcs will need to spend more time on in-depth communications programmes, although there should be a plenty of publicity from the IASB and the FASB directly before the new rules need to be implemented. In addition, it’s worth noting that institutional investors and experienced investors have always been accounting for leases anyway, and will have been aware of the changes for a long time – which is part of the reason the changes are being bought in.
Charlotte Vitty is finance director at Instant