With just days, not weeks, until the date of publishing a new lease accounting standard by the International Accounting Standards Board (IASB), it is time to look for a “bright side” outcome of the new standard.
It must be expected that in the weeks ahead opponents and contenders will give their arguments for and against. Many, among which the Big Four assurance firms, will tell that the new standard is flawed from a conceptual point - is complex to implement, yet doable.
In fact, what we are seeing is the introduction of ever-more directive instructions that in essence conflict with the notion of upholding a principles-based guidance. Exactly as requested by analysts, auditors and other user of accounts: set a rule so that we don’t have to interpret what we see.
And the IASB and Financial Accounting Standards Board (FASB) just did as requested – although not with convergence (between IASB and FASB) as initially intended.
This article is not about clarifying the differences although the different approaches highlight at least one relevant element: a lease is a combined product with individual risks for each aspect of the combined product. It is the angle from which one looks that affects the outcome: viewing a lease as a form of finance, financial risk takes the upper hand.
If looked from an asset perspective, the residual value risk takes the upper hand.
The struggle begins where parties become unclear about the mitigating circumstances. May the financier count on the compensating value from the sale of the asset? May the guarantor of the residual value count on receiving the asset or revenues from the sale of the asset?
Most of the time the outcome of the mixing of risks lies outside the accounting field: tax authorities, banks or guarantors, all have imputed their demands into the lease agreement. Accounting cannot simply solve the complications in a one-fits-all instruction. That’s where ‘principles-based’ should be introduced.
The new lease accounting standard tries to reduce ambiguity, eliminate structuring opportunities and avoid abuse in general. In order to uphold a principles-based character, instead of rules, “practical expedients” have been introduced.
No excuse of abuse
However, a practical expedient is no less than a rule: if one follows the practical expedient, one doesn’t have to think or explain. Perfect for robotic accounting and making auditing simple. And best of all there is no discussion of abuse as one merely is following an accepted line of conduct.
With abuse eliminated, we can start looking at new opportunities allowed within the framework of the new standard: where there is a rule, there is a line not to cross. How close to the edge should one get? Under principles-based accounting, it was hard to come too close to the edge as it was proof of bad taste and not observing the spirit of the guidelines.
Under rules-based, there is no inhibition not to get to the edge, unless for reasons of higher (financial) risks. So despite all the wording in the new leases standard, new ways for setting up leases will be found.
Perhaps not by the ‘usual suspects’ from the past, but by new entrants into the leasing market.
This may seem threatening to current providers of leases, but in fact a whole range of new opportunities will open.
The first new opportunity is for financiers. Lease transactions have a notion of being expensive compared to unsecured loans. In the past the better the credit standing of a (listed) company the more money was made available by bankers at ever lower interest prices.
Now, with leases on balance sheet, it becomes clear that ordinary unsecured lending has been too cheap for decades. The interest price of a lease correctly reflects the useful time of the asset at the user’s place, taking account of the financing of the residual value amount.
License to operate
The second new opportunity is for the leasing industry - with the booking of entries in accounting according to the finance lease type, and all leases being treated equally on balance sheet, why not structure the majority of leases as operating leases?
Complex? Well, no.
Just cut any lease contract in at least two pieces: a bare lease-financing for the intended lease period plus an annual “license to operate”.
When a full operating lease is contracted, just add one or more service elements in separate contracts. The new standard excludes licenses and the like from being leases, so only the bare financing will come on board of the balance sheet. And this is fully in line with the basic intentions of the IASB: one wouldn’t want to overinflate the balance sheet with loose assets like future services.
Note: As far as we know at this stage, the new standard tries to link almost simultaneously concluded contracts to be one (leasing) contract. However, when different parties are involved, it will be difficult to substantiate the presence of one (combined) transaction: it would suggest that every unsecured financing of an asset, its insurance contract and its maintenance contract, together, would become a lease at all times.
This is not so, not even when the same broker is involved in arranging the contracts with multiple parties, thus the opposite is also true: a “lease” comprising multiple elements is just a series of individual contracts.
The lessor company in the new era will primarily be the broker arranging the (lease) transaction, providing auxiliary services like monitoring the use and maintenance of an asset and … arranging the invoicing and collection of the lease payments. And possibly continue to have an interest in the residual value, as guarantor or legal owner.
The third new opportunity is for new entrants into the market. With lease contracts becoming more and more a combination of individual elements, new entrants may want to provide for just some of the elements. In this era of disruptive and innovative business modelling, a new equilibrium will arise. But this development would happen anyway, perhaps only speeded up by new regulations.
Pessimists in the equipment leasing industry fear that lessees will turn to straight line financing via banks and shy away from the complex reporting of leasing as proposed.
Pessimists in the full operating lease arena, some car leasing companies as an example, are afraid of disclosing the breakdown of a single lease payment.
I am optimistic. Not just because of the level playing field to arise. Sustainability requirements and environmental needs will incense further new developments. Perhaps not fitting in this current or upcoming lease accounting framework, but accounting should remain a mean anyway, not a target.
The level playing field that eventually will arise is just to the benefit of everybody:
• analysts, investors and banks will be able to better understand the balance sheets;
• banks will benefit from a better interest margin;
• pure lessors will benefit from increased understanding of their product by banks and increasingly focus on the service elements via license to operate contracts and new or newly structured services;
• legal departments and firms will find new wording fitting the changed regulation; and finally
• new entrants may come into play for securing the funding of the residual value amounts, new types of services, etc.
The real worries are about the way the IASB and standard setters in general work. It’s time to realise that the vast majority of enterprises are not listed and deserve better than guidelines derived from the full IFRS standards.
IFRS for SME’s is gaining ground in many countries, but is still based on a simplified full IFRS. One of the worst current examples within the IFRS for SME standard is in the field of leasing: hardly any allowances compared to the full IFRS.
It’s time for standard setters to start bottom-up, like just a few countries already have implemented: a layered approach of regulations starting bottom-up, fitting the various needs for the micro, the small, the mid-sized and the large corporates. And accept that reporting remains a model, at best simulating the truth.
Henk Uunk held the position of manager financial accounting and reporting at ING Lease Holding from 2004 to 2014. He is chairman of the accounting committee of the Dutch Leasing Association (NVL) and a member of Leaseurope’s accounting and taxation committee since 1992. Uunk is a contributor to the Dutch Accounting Standards Board working group on leases and acts as a consultant to the Dutch Car Leasing Association (VNA).