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The International Accounting Standards Board and its US counterpart have settled their differences over an accounting approach for leases, but compromise has created its own problems, says Jane Fuller

This article was first published in the July 2012 UK edition of Accounting and Business magazine.

It is 20 months since I attended a conference where Leaseurope, an umbrella body for leasing company associations, judged the proposed International Financial Reporting Standard (IFRS) ‘probably unworkable’.

Since then the most controversial details have been pruned and, on 13 June, the International Accounting Standards Board (IASB) and its US counterpart, the Financial Accounting Standards Board (FASB), agreed on a lease accounting approach. A revised exposure draft will be issued in the fourth quarter of this year, but an important milestone has been reached: the one that affects those precious profit numbers.

The development of this standard has been a test of the IASB’s pragmatism and willingness to listen to its ‘constituents’ – users of accounts, preparers and so on. It has also been a test of convergence between IFRS and US GAAP, which appeared to have stalled. However, the standard is not out of the woods.

The outcome tacks back to a distinction between different types of lease, as exists now between operating and finance leases under IAS 17: Leases. So an opportunity to have one accounting principle for a ‘right of use’ asset has been lost.

A hybrid model is proposed for treatment in the income statement. Property leases will be amortised in a straight line. This is because the lessee typically consumes little of the underlying asset, so the payments look very like rent – or an operating lease. For other leases, the right-of-use asset is amortised in a straight line and the financing element is split out. This gives a higher effective interest cost upfront, which reduces in line with the carrying value – much like a finance, or capital, lease.

This not only reverts to different treatments but muddies the view of the asset: is it an intangible right of use with discrete cashflows and obligations, or part of something physical that remains owned by someone else? It is easy for the debate on the nature of ownership to become philosophical.

In practice, the latest proposals are a concession to the retail sector. They also acknowledge limits to the amount of change both users and preparers can stomach. Retail analysts were as likely to want to keep the straight-line, operating model as preparers, who realised that the portfolio effect would smooth out the ‘upfront’ interest issue.

A more subtle divide between analysts saw some argue that you should look through to the underlying asset on all occasions. This means differentiating between compensating the asset owner for a) consuming part of it, and b) the capital used. Pursued to its logical conclusion, there would be different patterns of consumption versus financing costs for different types of asset. The boards are trying simply to apply this approach to assets like property, where the lessee consumes an insignificant portion of the value of the underlying asset.

There is nothing simple about this. Nice as it is to compromise, the accommodations create their own problems. These include opportunities for structuring around the line that divides one type of accounting from the other. Similar transactions will be accounted for differently by different companies and earnings before interest, taxes, depreciation and amortisation (EBITDA) will be manipulated.

To counter this, there will have to be extensive disclosures to show how the judgment was arrived at. Cue complaints from the industry that those requirements are too onerous.

In the end the prize for this standard is to bring lease assets and liabilities on to the balance sheet. Hooray for that. Haggling over what goes in the income statement ought to be a secondary issue. But we all know how precious those profit numbers are.

Jane Fuller is former financial editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think-tank

Last updated: 21 Mar 2014