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A hard landing leases under new IFRS rules

IT must be fairly depressing to labour at something for nine and a half long years only to find that the results of all your deliberations and revisions are regarded as misguided by key sections of the constituency you hoped to win over. Yet this is the fate the leasing standard seems almost certain to suffer when it is finally issued by the IASB sometime around November this year.

Some large companies with big-ticket leasing items that are currently off the books, such as leased aircraft and ships, are already so transparent – in their treatment and disclosure in the notes to the accounts as far as off-balance sheet leases are concerned – that they are unlikely to make much of a fuss in public about the new standard.

Typical of this approach is the response Financial Director received from the shipping giant Mærsk. Jan Kjærvik, head of group finance & risk management at Mærsk Group, commented: “Overall, we support the idea of bringing these types of liabilities more transparently to the balance sheet; we, however, also recognise that these are complex matters and that it is a challenge to clearly distinguish between the different types of leasing structures.

“We will adopt the recommended accounting standards and have no issues with so doing. We do have lease obligations, in particular on shorter-term time charters for vessels and on longer-term concession fees to our port businesses. As for the use of capital, we have for many years operated with an authority decision matrix and a financial policy for investment that caters for treating acquisitions of assets to the balance sheet the same way as treating lease obligations off the balance sheet. Thus, for us it is the same use of capital whether we buy or lease our assets.”

For a behemoth like the Mærsk Group, the cost of compliance probably doesn’t even amount to a rounding error on its annual P&L, so what the IASB wants, the IASB will get. The fact that the IASB has reversed its earlier position – where it agreed with FASB, which has worked with IASB on the draft, on the need to recognise the difference between operating and finance leases, and now does not recognise any such distinction – may cause Mærsk and other big organisations a few headaches. But they have the resources to figure out an appropriate response in line with whatever it is that IASB decides that it wants in the new standard.

Best of British

British Airways, or rather its parent, IAG, has long been regarded as a model of best practice for the way it discloses off-balance sheet leases in the notes to its annual accounts. BA declined to comment on the soon-to-be-issued leasing standard, referring us instead to the International Air Transport Association (IATA) for an industry-wide view. However, at the time of going to press, IATA was not in a position to provide such a view. It is not alone in this or in not wanting to stick out its neck in advance of the appearance of the standard. Stagecoach, for example, was just one of several companies with large lease commitments that decided this was not an issue it wanted to pronounce on in public yet.

Where the IASB is likely to run into considerable opposition is from UK and European plant, motor and equipment leasing companies. Julian Rose, who runs an asset financing consultancy, Asset Finance Policy, is a special adviser to Leaseurope, the European Federation of Leasing Company Associations. He has been closely involved in shaping Leaseurope’s response to the standard. He tells Financial Director that Leaseurope’s members are concerned that the complexities and the anticipated expense of compliance with the standard could cause some of their clients to eschew leasing as an option altogether. At the very least, the standard is seen as an unnecessary hurdle put in the way of the sales process, as far as leasing companies are concerned.

What is really frustrating for the leasing community, he says, is that if you look at the total value of off-the-books leasing by top companies, 96% of that value is made up of property leases, which have nothing to do with the nuts and bolts of plant, motor and equipment leasing. “Leaseurope’s members account for only 4% by value of this sum that the IASB wants to bring back onto the balance sheet. It is a truly insignificant sum that is not going to be of much help to investors when they are analysing a potential investment target, yet the implementation of the standard is likely to have far-reaching consequences for members,” he argues.

That 4% figure comes from a research study commissioned by the Finance and Leasing Association (FLA), the UK trade association for the consumer, motor and asset finance sectors. The FLA has plenty of “skin in the game” as its members have some £66bn in outstanding business loans with three-quarters of a million UK businesses of all sizes. The FLA asked Professor Marriot and Dr Pru Marriot of Winchester Business School to analyse UK-quoted companies to ascertain the proportion of property leases to other leases. Responding to the IASB’s original exposure draft, the FLA pointed out that of 225 quoted companies of all sizes included in the academics’ study, only ten – all in the telecoms or transportation sectors – had non-property leases that were more significant than property leases.

On average, the split was £445m (96%) for property and only £18m (4%) for all other leases. Given that, it is hard to argue with the FLA’s comment that “there is likely to be limited benefit to users of accounts of almost all UK companies of putting non-property operating leases on the balance sheet”. The FLA also notes that the study shows that there is minimal “structuring” of non-property leases in the UK.

Solving one problem…

Another point that both the FLA and Leaseurope make is that in going for a “right of use” definition of what constitutes a lease, the IASB is creating at least as many problems as it is solving. The FLA argues that the definition of a lease as “right of use” of the asset is too broad: “It would create confusion by leading to many contracts that are today considered to be services being accounted for as leases, and many contracts that are today considered to be leases being accounted for as sales.”

Julian Rose says, based on talking to Leaseurope members, that it is clear many finance directors in major companies have not yet given much thought to the leasing standard. “The average equipment lessees are going to get a shock when they see the work involved in complying with the new standard, when it comes in, and the expensive and extensive disclosures that are going to be required of them,” he says.

For his part, Rose points out that there is no certainty the leasing standard will gain acceptance at the European level even after it is released by the IASB. “The standard still has to be ratified by the European Financial Reporting Advisory Group (EFRAG), and to do this, EFRAG will need to be convinced that the standard is in the public interest. Studies have shown that leasing is a vital source of financing for Europe’s SMEs so anything that impacts investment by SMEs will be negative for the European economy. It seems to me to be unlikely that EFRAG and the European Parliament would be happy to risk such an outcome by ratifying the leasing standard,” he comments.

He may be right, but EFRAG and the IASB are at present working jointly, along with the various national standard setters, on a public survey on the potential impact of the new IFRS on leases. The deadline for responses is the end of September 2015. As yet, it is unclear how much or how little the IASB is prepared to alter the standard at this late stage, given that it has already completed its deliberations and has now been pondering the issues for the past nine and a half years.

PwC partner Roger de Peyrecave has a great deal of experience with airline audits and is well aware of the complexities that leases pose when it comes to airline accounts. One of the major complications, he points out, can be the way in which a lease treats the big-ticket engine maintenance and aircraft maintenance “moments” in an aircraft’s life cycle. Depending on how the contract is written and how much risk for the usefulness of the asset lies with the leasing company rather than with the lessor, these contracts could be deemed to be service agreements rather than leases.

“Where the leasing company provides the aircraft and crew and is responsible for the asset being ready to fly – an arrangement the industry calls a “wet lease” – at present an airline would deem that to be a service contract. However, if you look at where the capital risk lies in a lease, with the airline sector this is often in a grey area, given that aircraft are extremely long-lived assets and that leases are typically only for portions of the life of that aircraft,” he notes.

Sweeping complexities

However prescriptive it wishes to be, the leasing standard will clearly struggle to sweep these complexities in with, say, car leasing. Depreciation is at least as much of a problem. “Depreciation in airline accounting is quite complicated. There is a heavy maintenance cost with the asset and where that leads you is not that obvious to a lay reader of the accounts,” he says.

Part of the problem is that there is no obligation on the airline to maintain the aircraft, so companies do not set up a maintenance provision. Instead, they recognise the reality of maintenance as an issue by treating the aircraft as fully maintained on acquisition and then depreciating it faster through to the next maintenance event. Then the maintenance expenditure is capitalised and is in turn depreciated. De Peyrecave points out that with an operating lease, by way of contrast, there will be an obligation in the contract to maintain the aircraft, so there will be a provision established that will build up over the period to the next big maintenance event. This will show up in operating expenses as a maintenance cost.

But there will be no such line item in the accounts of a wholly owned fleet, which will instead show a steeper and slightly more complex depreciation pattern.

“In terms of understanding the income statement and balance sheet of an airline company, it is much more complicated for the reader than simply saying, ‘I am going to capitalise the lease and put it on the balance sheet.’ Airlines will work out how to respond to the standard to cope with it, but you will not get an equivalent depreciation charge for a capitalised leased aircraft as for a wholly owned aircraft, despite the efforts of the IASB,” he concludes. ?

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