The End of the Operating Lease

Introduction

Proposed changes to lease accounting would mean that leased assets would always appear on the balance sheet.

"We all have leasing standards, and the great news is these leasing standards are perfectly harmonised world-wide. They are all absolutely useless. None of them work."

(Sir David Tweedie, Chairman of the IASB, speaking in Sydney in 2002)

The IASB (the global setter of accounting standards) has recently published its proposals for the reform of lease accounting. These proposals might be considered the final legacy of the outgoing Chairman, Sir David Tweedie, who has long stated that he intends to address this area before his retirement. Pressure for reform in this area has also emerged as a result of the global financial crisis, with suggestions that lease accounting may be used by companies to hide liabilities by removing them from the balance sheet.

The current proposals form part of the project of the IASB and the FASB (the USA's Standards Board) to create a single global set of financial reporting standards.

Accounting for Leases

The IASB's proposals would effectively remove the current distinction between finance and operating leases. All leases would be shown 'on' the balance sheet, as a leased asset and a corresponding liability.

• For leases less than 12 months, the asset and the liability will be the sum of the total lease payments, which will be amortised on a straight-line basis over the term of the lease.
• For leases greater than 12 months, straight-line expense will not apply, and will be replaced by interest plus amortisation. This will be calculated as if the leased asset was purchased and financed, so the expense will be higher in the early years of the lease.
• Assets under lease, and the corresponding liabilities, will be initially recognised and subsequently carried at amortised cost, based on the present value of payments to be made over the term of the lease.
• Any optional renewal periods where the option to renew is more likely than not to be exercised should be included in the lease term.
• Lease payments used to calculate the initial value of the asset and liability will include estimated "contingent" amounts, such as rents based on a percentage of a retailer's sales, or on indexed rent increases. These will need to be re-estimated at each reporting period throughout the life of the lease.
• Leases already entered into at the transition date are not grandfathered – they will need to be restated.

Accounting by a Lessor

There will be two models that a lessor may apply, depending on whether they retain the risks and rewards of ownership of the leased asset:

• Where such risks are retained, the leased asset will remain on the balance sheet. However, a receivable will be recognised for the present value of the lease payments, together with a corresponding liability representing the obligation to provide the asset for use.
• Where the risks and rewards of ownership are not retained, the asset will be treated as if it has, in substance, been sold.

It is worth noting that, under the first approach, the same asset may be on two companies' balance sheets simultaneously!

When will it Apply?

These proposals are currently in the Exposure Draft stage, with no firm date for transition set. A final standard is expected to be issued during 2011, and early-adoption is likely to be permitted. Mandatory transition is unlikely to occur before 2014.

What are the Potential Implications?

Given the almost universal nature of leasing, the requirement to restate all lease assets and liabilities is likely to be a significant challenge in the year of initial adoption. The abolition of the operating lease will not only mean that balance sheets will grow larger, but also that anything previously classified as rent expense will now be shown as depreciation and interest.

• The requirement to show all liabilities 'on' balance sheet will affect capital ratios, and may affect compliance with lending covenants, particularly where this include restrictions on gearing, or other ratios based on liabilities against assets. Businesses looking to negotiate finance should consider the potential effect of lease accounting proposals on lending covenant compliance.
• The replacement of today's straightline approach of operating leases with the front-loaded recognition of the interest expense may affect the timing of earnings associated with major projects or asset groups.
• For those companies looking to avoid a large gross-up of the balance sheet, it may be preferable to negotiate shorter lease terms, and to avoid leases with renewal clauses.
• The requirement to estimate contingent elements of lease rentals at each reporting period is likely to lead to greater income statement volatility.
• However, EBITDA and similar measures of income are likely to be impacted positively, as rental operating expenses are now classified as interest and depreciation.

Crowe Horwath in Australia

Crowe Horwath works with companies and individuals to maximise their growth potential and achieve financial goals. The firm's team of more than 800 principals and professionals delivers a full range of accounting including, audit and taxation, business advisory, corporate finance and wealth management services nationally from offices in Brisbane, Melbourne, Perth and Sydney. Crowe Horwath is an integral part of the ASX-listed WHK Group – Australia's fifth largest accounting services group – and a member of the global Crowe Horwath International network. Crowe Horwath International is ranked among the world's top-ten accounting networks and comprises more than 140 independent accounting and advisory services firms in more than 100 countries. See www.crowehorwath.com.au.

For Further Information

For further information please contact your local Crowe Horwath representative.

Leah Russell

Head of Audit and Assurance, Sydney

Tel +61 2 9619 1735

leah.russell@crowehorwath.com.au

Sean McGurk

Head of Audit and Assurance, Perth

Tel +61 8 9488 1162

sean.mcgurk@crowehorwath.com.au

John Gavens

Head of Audit and Assurance, Melbourne

Tel +61 3 9258 6823

john.gavens@crowehorwath.com.au

Vanessa de Waal

Head of Audit and Assurance, Brisbane

Tel +61 7 3233 3492

vanessa.dewaal@crowehorwath.com.au

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.