Lease accounting

In the third quarter of 2008, the international and US standard setters plan to issue jointly a discussion paper on lease accounting. As noted in the International Accounting Standards Board’s (IASB) background paper prepared for observers at its July 2006 meeting (the July 2006 paper), the project is expected to result in a “fundamental change” in accounting for leases by both lessors and lessees.

Lease accounting is important, not least because of the size and reach of the leasing industry. According to the US Equipment Leasing Association, of the $850bn spent by American businesses on productive assets in 2006, $229bn, or 27%, is estimated to be acquired through leasing. As outlined in the IASB’s July 2006 paper, leasing is a major international industry, with total leasing volume in 2004 reported as $579bn. “Everything from small bits of equipment like PCs up to the corporate headquarters may be leased,” says Rachel Knubley, project manager at the IASB. Lease accounting therefore affects the financial statements of almost every business and public body.

Unfortunately, the current approach to lease accounting is widely considered unsatisfactory. Lease accounting is addressed by International Accounting Standard (IAS) 17, the US’ Statement of Financial Accounting Standards 13, and the UK’s Statement of Standard Accounting Practice 21. The model used in these standards distinguishes between leases that transfer substantially all the risks and rewards of ownership of the leased item to the lessee (finance leases), and those that do not (operating leases). Finance leases create an asset and liability in the lessee’s accounts, while operating leases are accounted for only as rental obligations accrue.

Applying this model requires considerable subjective judgement, for example, in interpreting what is meant by “substantially all the risks and rewards of ownership”. The result can be that different accounting is applied to very similar lease arrangements. “You can have leases that are operationally or economically very similar, being accounted for in very different ways, and that’s not very satisfactory,” says Knubley. This creates the possibility to structure lease arrangements simply to achieve the desired accounting effect.

Danielle Zeyher, project manager at the US Financial Accounting Standards Board (FASB), believes that revising lease accounting would “increase transparency for investors and other users of financial information”. She says: “There is a lot of concern that the current accounting provides an ability to achieve desired accounting outcomes that may not faithfully represent the underlying economics.”

A major problem is that assets and liabilities may not be being recognised properly. “Some of the concerns,” Zeyher explains, “are that there are obligations that are not being recognised on the balance sheet, as well as assets that are not being recognised on the balance sheet of lessors and lessees.”

The IASB and FASB want to address these problems in their joint project. “We are hoping to come up with something more principles-based,” says Zeyher.

The overarching idea is to develop a single model for recognition and measurement of assets and liabilities arising under lease arrangements. This would remove the current finance/operating lease split, though an exemption for very short-term or immaterial leases might be considered.

“It’s very early days,” Knubley stresses. “We want to have a look at lots of different models and see which one makes most sense given the accounting framework we have. But we are almost certainly going to end up with more assets and liabilities on the balance sheet.” Knubley refers to the discussion papers published back in 1999 by the group of standard setters known as the G4+1. “They propose a certain way of approaching lease accounting, to account for the rights and obligations that arise,” she says. “So a non-cancellable operating lease would be capitalised and the obligation to pay recognised on the balance sheet. That approach is still quite attractive.”

Peter Hogarth, a director in PricewaterhouseCoopers’ accounting consulting services, would support the distinction between operating and finance leases being removed. He recalls the firm’s response to the G4+1 discussion papers of 1999. “We said we agreed that the existing distinction between operating and finance leases was not working well and needed replacing,” he says. “We are encouraged that it [lease accounting] is on the agenda. It’s an important project that needs to be addressed.” The firm did have some concerns with the G4+1 proposals, however, and will be watching closely how the joint IASB–FASB project develops.

Cost impact

The IASB is aware of the need to consider the cost impact of changing accounting requirements, balancing any such costs against the benefits of improved transparency in financial reporting. Its July 2006 paper suggests that a new accounting model for leases would not necessarily be more costly than existing models, although for more complex leases it may be necessary to separate out some features of the transaction and account for these separately. There might also be more complex accounting for leases that are currently operating leases, and where lease rentals are accounted for on a simple accruals basis.

The international standard setter also acknowledges that business decisions could potentially be affected. Its July 2006 paper says that “a new accounting model may significantly alter the balance between the various alternatives for financing; whilst this will produce both ‘winners’ and ‘losers’, this will be perceived as a cost to the losers.”

“There will probably be some people that are not happy with it,” says Zeyher. “However, at the end of the day, we want to make sure the accounting properly reflects the economics. Better and more transparent information enables investors, creditors and other users of the financial statements to make better informed decisions. Potentially, people will lease because it’s economically feasible to lease, as opposed to because of the accounting.”

Knubley notes that it is difficult to comment on potential winners and losers at this stage. “Until we know what the accounting would look like, it’s hard to say whether it would have an economic effect,” she says.

Craig Pickering, a consultant at the UK’s Finance and Leasing Association, predicts that the project to rewrite the lease accounting standard will be “the biggest thing in my in-tray for the next couple of years”. Alongside understandable concern about how the industry could be affected by a new accounting model, he is also hopeful that there may be benefits arising from a fresh look at lease accounting.

“There are a couple of things in IAS 17 which, as far as UK lessors are concerned, were a change for the worse,” says Pickering. “It treats tax in what the industry thinks is quite an odd way. It makes a lot of deals look loss-making in the early years when they were profitable under UK GAAP, and we believe they are profitable in economic and commercial terms. That doesn’t make sense.” Pickering also has a problem with IAS 17’s insistence on straight-line depreciation for operating leases. “Assets depreciate in different ways,” he says. “Straight-lining everything doesn’t seem the most sensible way. Maybe the new standard will address these concerns, so there are opportunities as well as possible risks.”

Sarah Perrin is an accountant and writer.