Representatives from the International Accounting Standards Board and PwC met to discuss how lease accounting changes will affect lessees, highlighting possible behavioural changes. Brian Cantwell reports

Globally, about three trillion leases will come onto the balance sheets of listed companies in 2019, and a quarter of those leases will be in Europe. It is estimated that £200bn (€255m) worth of leases will come onto balance sheets of UK retailers.

At a briefing at the Chartered Accountants’ Hall hosted by the Institute of Chartered Accountants of England and Wales on 10 May, Kathryn Donkersley, senior technical manager at the International Accounting Standards Board (IASB), and Kirsty Ward, accounting advisory partner at PwC, highlighted the exemptions for listed companies and said they could influence behaviour.

"Leasing is done for good economic reasons, and those economic reasons are still there. I’m not sure that it’s going to be necessarily different for larger organisations versus middle-ticket organisations," said Ward.

"I think it probably depends on the level of debt that they take on board and where they are in relation to their debt covenants.

"In terms of the behaviours, I expect we will see more looking at how things can be structured to be a service; we will be looking at more turnover-based leases, lease versus buy decisions being revaluated, splitting assets up into smaller components if they can. I think there will be lots of areas where companies will investigate their options if they are looking to reduce their debt."

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In terms of what is a service or what is a lease there is a lot work to be done, it was agreed at the briefing.

‘Componentisation’ (explaining assets on the lease and any additional assets) for assets and how lessors and lessees draft the lease contract will be key.

Second elements in the contracts can be strict; even a property lease can be called a service, and it will make a huge difference, the accountants said. The amount of debt can be reduced. We will see that leasing contracts will change over time: from leases to services.

Changing behaviour

Donkersley highlighted the general changes that lessees would face, which will arguably set the framework for decision-makers at these businesses in future.

She said: "There are two types of lease, that if the lease meets two types of criteria as identified by the IASB, then a lessee can choose not to recognise assets and liabilities for those leases, but can continue to account for them similarly to operating leases previously.

"Those two categories are short-term leases, defined by the Standard as a term of less than 12 months after doing the ‘reasonably certain’ assessments.

"That exemption could be applied to any leases with those 12-months terms. The other category we refer to as leases of low-value assets.

"You might imagine that low value might be quite difficult to define. IFRS 16 and the associated application guidance and illustrative examples have quite a lot of guidance about the kinds of things that do fall within the criteria for being leases of low-value assets."

The uncertainty of the future asset

Donkersley continued: "I will mention one point of particular interest: in the basis for conclusions that we put out with the Standard, we do talk about the fact that when the board were thinking about this low-value asset exemption in 2015, they had in mind assets with the order of magnitude of around $5,000 (€4,400)when new.

"We don’t normally put figures in, but there is the example of the tablet computer that made its way into the notes for the Standard and would be described as a low-value asset, but 20 years ago it wouldn’t have been considered a low-value asset.

"We don’t know what will be considered a low-value asset in 20 years’ time, and what assets might have been introduced to the world by then. So the board wanted to give something clear to give people an example, in order to show what they had in mind when they were thinking about that exemption. So for those two things there is that choice to not recognise these things."

The definition of a lease – service as exemption

Today, accounting for services and operating leases is pretty much the same, and therefore the distinction is not quite as critical as it will be when IFRS 16 is implemented and leases are recognised in the balance sheet, whereas services aren’t. It’s something that has gained a lot of discussion and interest during the project.

PwC’s Ward said: "What’s a service, versus what’s a lease? In the past, it hasn’t really mattered as it was all treated as an expense.
"Now you really have to account for those two components separately. You have to think about what does this contract actually relate to?

"If it’s a photocopier, are you leasing the underlying asset, or are you actually getting the underlying asset of having a certain amount of pages being copied?

"And if you look at how lessor businesses which lease photocopiers advertise themselves, they portray themselves as a service companies.

"They don’t tell you they are all about leasing you an asset; they tell you that you are going to get a service.

"There are benefits to having your contracts as a service, as opposed to a lease. If it’s a service, it doesn’t come onto your balance sheet as a liability.

"There are some benefits at looking at what could be called a service component versus what could be called a lease component. There’s a practical expedient, that if you wanted to distort it all as a lease then that is fine, but most people will want to have a bit of a look as to what’s a service and what is a lease."

Lessee behaviour could change on variable payments

Ward said: "Those variable payments are only included within your liability where it’s related to an index.

"If you’re a retailer and you have lots of real estate leases, you might want to think about whether or not some of those could have a higher amount that relates to turnover.

"Instead of leasing a truck, or a railcar carriage, you might end up buying a service where you get to ship a certain number of items rather than having an identified asset on which you’re leasing.

"We’re going to see things evolve as people start to have a look at really what do they want to do, with some of their contracts as they start to evaluate the impact of IFRS 16."

Other practical implications for lessees

Leasing Life asked what effect the Standard will have on behaviours as the average increased debt of retailers is going to increase dramatically when the Standard takes effect.

Ward said: "You can imagine in a world where people think debt is bad, the debt increase is going to have a big impact, in terms of how lessees communicate what is going on in financial statements, and why you have a debt number that has almost doubled. In terms of practical implications, there’s a large financial impact of increasing the debt number.

"On average, a lessee’s profit profile might look the same or slightly different, depending on what is happening in their portfolio of leases.

"The Standard doesn’t change the underlying economics of what is going on.

"Instead, the Standard is putting them on the balance sheet to present them differently.

"It’s going to be very important that companies explain very clearly what has come onto the balance sheet and why it is the way it is, and when PwC talks to analysts, particularly retail analysts, they give us the feedback that flexibility and leases, particularly real estate leases, are very important.

"If lessees bring on large numbers onto the balance sheet, analysts are going to start questioning the lessee’s flexibility, and what is in the lease portfolio. In theory they should know all of that information, it’s in the disclosures, they could have asked, but some analysts don’t have a lot of time to go through all of the detailed information that’s within statements; they might just see underlying debt going up, which must be explained."

Debt covenants

Debt covenants are going to have to be negotiated with the banks how they are to be changed, particularly if they are not written under frozen GAAP, according to Ward.

"Banks love to charge for changes, so they will be finding opportunities to charge lessees for this, so proactivity on negotiations will help lessees in this circumstance.

"Some of the operational implications – if you talk to some of the people who manage leases for a living, they will tell you that in order to pull together lease contracts, which are currently scattered throughout an organisation, it can take between nine to 12 months, just to pull together all of those documents.

"That’s because leases are written all throughout the organisation, all the time, for different reasons. So proactivity and engagement between lessors and lessees will be key"