In 2016 a major revision of the accounting requirements for leases is set to have a significant impact on huge swathes of industries doing business internationally who rely on leasing assets as a way of doing business. International Accounting Standards Board (IASB) now requires that all leases be reported on balance sheet as assets and liabilities. Generally Accepted Accounting Principles (GAAP) does not have the same requirement.
Prior to 2016, it was estimated that about 85% of leases were being recorded off-balance sheet. The treatment of lease expenses won’t change on the income statement however, still making the full value of a lease payment is a business expense. It does require though that lease obligations be reported on the balance sheet for the first time ever.
GAAP allows the company to categorize leases into two different buckets. One is a finance lease, typically used to buy equipment where the ownership of the asset is transferred to the lessee at the end of the term. This type of lease is recorded as an asset for the lessee on the balance sheet.
The other type of lease is an operating lease. Under this type of financing arrangement, the lessee can return the equipment to the lessor at the end of the lease period without any further obligation. These types of leases are treated as a business expense, and reported in the notes of a financial statement or “off-balance sheet items”.
One of the primary advantages of the rule change is to provide transparency into the financial obligations of a company from the lender or investor point of view. By requiring all leases to be recorded as assets and liabilities, investors can more accurately compare the effects of leasing activities from a liability standpoint. Until now the effects were estimated based on the information contained in the notes. To be safe, the best practice was to overestimate the liability effect on future cash flow.
Many investors made their own adjustments by multiplying lease payments by 7-8 times in order to roughly estimate the financial obligation of a company. This method often resulted in an inflated liability estimate and did not reflect the company’s current economic reality. On the other hand, some investors made no adjustment, leading them to underestimate the company’s obligations.
This new standard makes these liabilities more apparent to all investors. It also allows for better comparability between two companies in a similar industry. In the airline industry for example, some companies buy their airplanes and show a lot of debt on the balance sheet. A similar company may be leasing their airplanes and only record the arrangement in the notes or off balance sheet. This gives the impression that the second company has a cleaner balance sheet and is therefore in better financial condition.
While investors are the prime beneficiary of this rule change by the IASB, some companies may find themselves in a difficult situation when doing business within the US and operating under GAAP. GAAP still allows for operating leases to be recorded in the notes. In a controversial move, some companies doing business internationally may have to maintain two sets of books to adhere to both accounting standards. In all, the rule change is proving an administrative challenge for US based companies. The fall out is yet to be determined.