No Accounting for Leases April 2016

Both the IASB (International Accounting Standards Board) and the US-based FASB (Financial Accounting Standards Board) earlier this year announced new accounting standards to cover the reporting of leased assets. Both standards will come into effect by 2019 and may materially impact the presentation of accounts and financial decision-making by both airlines and lessors. The standards are similar but there are some fundamental differences.

The two standards boards have been working on a joint attempt to come up with a common standard for the last ten years. The main reason for the change has been concerns, specifically from the SEC, that the treatment of off-balance sheet items severely distorts the ordinary investor's view of the actual position of a company's state of affairs. Professional investors and analysts have for years adjusted the numbers from published accounts to judge risk and enable a reasonable comparison on a like-for-like basis, but the man in the street is deemed to need protection.

The IASB says that over 14,000 listed companies using IFRS or US GAAP (out of a total 30,000) disclose information about off-balance sheet leases in their annual reports and that the future payments showed totalled US$2,860bn. It has analysed a sample of 1,145 (3.8% of the total) companies (see table) which reveals that they account for 80% or US$2,196bn. The airline industry is the lead sector for this form of financing with future undiscounted operating lease payments possibly accounting for 29% of on-balance sheet assets.

The current accounting standards (IAS 17) provide for a distinction between leased assets depending on the status of ultimate ownership at the end of the lease period. In general terms if ownership reverts to the operator at the end of the lease this becomes a finance (or capital) lease and should be capitalised with a corresponding debt liability reflecting future lease payments, whereas if ownership resides with and remains with the lessor at the end of the lease this becomes an “operating lease”, remains off-balance sheet and the lease cost is expensed in operating costs as cash outflow.

The new rules from the IASB affecting IFRS accounts will do away with the distinction between finance and operating leases requiring all leased assets to be capitalised on the balance sheet (with the exception of leases with a duration of less than a year and leases involving low cost items such as personal computers).

In practice?

What does all this mean in practise? On the balance sheet a company will have to capitalise the net present value of future lease payments at a certain discount rate matched by a lease liability reflecting the value of the notional loan attached. This will boost total fixed assets and liabilities.

Through the income statement the company will depreciate the notional capitalised asset over the life of the lease, amortise the loan and record interest payments. This will reduce operating costs (which will no longer include lease rentals), increase EBITDA and EBIT, (with part of the cost of the lease allocated to depreciation) but should make little or no difference at the pre-tax level.

It will also increase gearing, reduce RoCE and interest coverage in the published figures (as both debt and capital employed are higher) but may increase RoE (as equity will be lower). Whether it has an effect at the net level will depend on local tax authorities' intelligence. On cash flow (which is the only thing that is really important) there will be no change — since this is all cosmetic — although individual reporting lines will become more incomprehensible and it may be more difficult to work out what is really happening.

For an individual operating leased asset the new standards will mean that costs will be front-loaded in the profit and loss account (see chart). It is not certain how wet-leased aircraft will be treated, but if the lease term is for longer than twelve months, the asset element of the lease will probably have to be capitalised.

The standards require that the future lease payment stream be discounted but allows the company to choose the discount rate either as the implicit interest rate inherent in the lease term or the company's marginal rate of borrowing. This may cause some problems. In the airline industry it is unlikely that the lessor would divulge the information (somewhat commercially sensitive exposure of their funding and residual value assumptions), while a 25% increase in nominal "debt" (see table) could have a material effect on the marginal rate.

Furthermore, for the first year of introduction, companies will be allowed to choose a transition method: either present all leases as if the standard had always been in effect (which will mean taking a hit to reported equity) or start as if from day one (which will increase future costs and reduce future earnings).

The US based FASB (affecting US GAAP reporting) has taken a slightly different view and has retained the definitions of finance and operating lease. All leased assets (excluding short term operating leases) must be capitalised. Operating leases are to be shown on the balance sheet as a "right-of-use" asset and a corresponding lease liability initially measured as the present value of future lease payments but recognise a single lease cost in the income statement calculated so that the cost of the lease is allocated over the lease term on a straight-line basis.

One of the more intriguing aspects of the new standards is that a company will no longer be able to record a profit as the result of a sale and lease-back agreement if that deal is regarded as a refinancing of the asset. In the airline industry this historically has been a convenient method of taking advantage of the difference between agreed discounted purchases from the manufacturers and current market valuations of aircraft in order to boost equity — especially for weak carriers.

Aircraft lessors get off lightly under the new standards. All they will be required to do is provide more detailed information on their residual value risks of the leased assets under management. Good news for the aircraft appraisers!

What really changes? Under current IAS 17 rules most professional advisers and analysts adjust the published numbers anyway. The common practise is to capitalise operating lease rentals at 7-8x (or a capitalisation rate of 12-14%) to add a nominal amount to debt and enterprise value (which is far too complicated a concept for the standards boards) to allow for inter-company comparisons. No doubt the common practice will change: but perhaps over time the markets will foolishly come to expect that what is presented in a set of report and accounts really represents a true a fair view of the state of a company's affairs.

Even more intriguing is what the rule changes may mean for behaviour. When it makes no difference as to which method of asset finance you pursue for reporting basis, the company's board of directors will always favour the method that creates the best returns under which they are measured. Although the availability of cash and capital will always be the deciding factor.

The IASB assumes that most companies will have a balanced portfolio of leased assets. For the cyclical airline industry, however, aircraft portfolios can change and this could well be yet another accounting standard that will increase the volatility of reported earnings.

Accountancy is an art — but the standards boards for obvious reasons do not want to believe that it is anything other than a science. As the old joke goes, a good accountant when asked what is one plus one responds “the answer is two”; a clever accountant says “I think the answer is two”; but the brilliant accountant in return asks “what number did you have in mind?”.