article banner

A tale of two balance sheets

Author: Ian Charles

Businesses have always had two ways of obtaining the use of an asset – they either buy it outright (often borrowing to do this) or they rent it under a lease.  In both cases they have the opportunity to use the asset how they wish, generating a return from the product(s) produced and facing similar risks (repair, obsolescence, damage etc.).

Clearly a purchased asset appears in the balance sheet and is depreciated in the income statement.  And yet accounting standards (internationally IAS 17, US GAAP and many national GAAPs) currently have two ways that the lease agreement can be depicted in the financial statements, depending on somewhat subjective, often arbitrary, tests of the economic substance of the agreement (and in US GAAP, a typical “bright line” test).  One method, the “finance” lease method, recognises in the balance sheet an asset (a “usage right”), a liability (“finance lease obligation”) and in the income statement entries that reflect amortisation and interest on borrowings.  The other method, the “operating” lease method, recognises no asset, no continuing obligation and only a rental expense in the income statement.  A tale of two balance sheets, portraying very different assets employed and obligations owed, and yet not so much of a difference in terms of economics.

This is all about to change!  For many years now the International Accounting Standards Board (IASB) and the US accounting standards body (FASB) have been working jointly to eliminate such a dramatic apparent difference in what are economically similar circumstances.  Does anybody care about this?  Well there is little doubt that the investor community, lenders, credit rating agencies and commentators (including politicians) have for many years lobbied for a change. The adjustments that are attempted to try and portray the effective assets employed and liabilities incurred are just too arbitrary and subjective to be helpful. The status quo cannot be tolerated any longer – doing nothing is not an option and a mere disclosure solution doesn’t solve the problem.  Operating lease disclosure is what we have at the moment and it fails to inform the reader how to adjust the balance sheet.

The document that describes the current thinking is an exposure draft of a proposed new IFRS (and a new US Standard) published in May 2013 and is a significant step forward from the original proposals in August 2010.  There have been a number of refinements made to the original proposals but the central point remains – all lease arrangements will come “on balance sheet” for lessees.  This is due to be finalised in the second half of 2014 with a mandatory effective date of (probably) 1 January 2017.  Between now and then companies need to examine their leasing commitments and identify the accounting impact.

Besides including the headlines of an asset and a liability recognition in the balance sheet for what are currently termed operating leases, businesses need to consider what that will do to their business model and apparent performance.  Any metric, that uses assets employed and liabilities to be met, will be affected.  For example, gearing ratios measured from the balance sheet will appear to become worse – this might lead to a business breaching its bank covenants.  Return on assets (ROA) employed will apparently decline significantly affecting bonus plans that are often referenced to ROA.  The current part of a lease liability will be presented within current liabilities affecting current and liquid ratios.

Now is the time to start modelling the impact of treating all leases as if they were finance leases, using the present value of minimum lease payments as the measure of the “usage right” asset and liability.  Then businesses should determine what these adjustments do to key performance metrics and the ability to stay within a bank loan covenant.  There are too many businesses that are walking into this change in financial reporting without appreciating the impact, despite the warnings that have been sounded.