On 17 August 2010, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) issued an Exposure Draft on leases. This Exposure Draft proposed a new lessee and lessor accounting model that would significantly change the way companies account for leases today.
Under the lessee proposals, the current distinction between operating leases and finance leases will be eliminated and all leases will be accounted for on balance sheet. Income statement ‘geography’ and timing of recognition will change. Straight-line rent expense will be replaced by depreciation, which will be recognised on a basis similar to similar owned assets, and interest expense, which will be recognised on a basis similar to a loan.
Under the lessor proposals, lessors will account for leases using a hybrid model, either a ‘Performance Obligation’ or a ‘Derecognition’ approach dependent on whether the lessor retains significant risks and benefits of the underlying asset. The proposed lease accounting does not currently include grandfathering for existing leases. Therefore companies should consider the impact of the proposed lease accounting changes when entering into new leases today.
PwC has performed a benchmark research to assess the impact of the proposed lessee accounting changes on the financial statements and key financial ratios of a sample of approximately 3,000 listed companies / lessees across a range of industries and locations. The study identifies the minimum impact of capitalising the operating lease commitments disclosed in the published financial statements. In view of the proposed inclusion of contingent rentals, residual value guarantees and lease extension options, the eventual impact may be much greater and may also impact the amounts recognised for finance leases. Furthermore, the study takes no account of any transitional reliefs that may be available on first-time adoption of any new standard.
Highlights from the study include: The average increase in entities’ interest-bearing debt would be around 58%; The average increase in leverage (interest-bearing debt / equity) would be around 13% and the average increase in EBITDA would be around 18%. The range of potential impacts is wide, but 24% would experience an increase in debt of over 25%. The impact also differs significantly from industry to industry. Industries that will experience the most significant impact on reported financial ratios are likely to be:
Analysts, banks and rating agencies generally use a ‘rule of thumb’ to adjust the financial statements for the effects of operating leases. This ‘rule of thumb’ might differ significantly from the actual impact of adopting the revised standard.