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How companies report their lease liabilities look set to be overhauled as the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) issue Exposure Draft says accountants Isis Business Solutions and commercial property agency prop-search.com
Mark Hollyman, a Director of Isis Business: “The primary objective of the proposed new rules are to demystify lease accounting and bring all leases onto a companies balance sheet in order to provide investors with a more accurate financial picture - so operating leases could soon be a thing of the past.”
“There is however fear that this could have a detrimental effect on lease lengths, a company credit ratings and ability to borrow”, adds Samantha Jones, a Surveyor at prop-search.com
Under the proposals, the lessee’s ‘right-of-use’ asset would be recognized initially at a cost equal the present value of the lease payments, discounted using the lessee’s incremental borrowing rate. This ‘right-of-use’ asset would then be amortized on a straight-line basis over the lease term or the economic life of the leased property.
Similarly, the lessee’s obligation to pay rent liability should be measured initially using the same method as measuring the ‘right-of-use’ asset. However, a subsequent measurement would be on an amortized cost basis factoring in the interest expense as it relates to the current liability balance.
Due to the unfavorable balance sheet impact under the proposed standards, lessees may prefer shorter lease terms to recognize a lower amount of ‘right-of-use’ asset and obligation to pay rent liability. However, there is a delicate balance between the lessee’s and the lessor’s financial and economic objectives. A lessee would perhaps prefer a short-term lease while a lessor would require a longer term to amortize any capital outlay.
Samantha continues: “The accounting model under consideration would affect virtually every company and will no doubt lead to inter-company debates when weighing the need to a long-term practical and operational perspective, versus the need for a shorter-term lease from a financial perspective.”
In the past a significant proportion of companies have avoided property ownership due to its negative impact on a balance sheet. However, if leases are to be recognized as assets with corresponding liabilities under the proposed new standards, the negative impact of building ownership on the financial statement could be less severe when compared to leasing. This in turn could have an impact on the rental market and some businesses may decide that freehold investment is a preferred option - although they could be hindered by many banks stringent lending criteria.
Of course banks themselves are major lessees, holding thousands of properties in shopping malls and high street. Many of their leases are currently hidden off balance sheets and under the proposals if a bank still holds the risks associated with a leased asset, it must too report an associated liability. Increased liabilities are bad for banks which are bound by capital requirements set by regulators and if as a result of new accounting procedures the bank’s balance sheet lists towards the liability side, its ability to lend shrinks.
Although a final standard is not expected until 2011, Isis Business Solutions and prop-search.com advise that companies should immediately consider the implications of the changes being considered, particularly if long-term leases are in place. Companies now have until 15 December 2010 to comment on the draft. The final standards are expected to be revealed in 2011 and the effective date is anticipated for the financial year 2012-13.