New lease accounting standard brings added transparency to the balance sheet

New lease accounting standard

The new standard requires companies to bring most leases on-balance sheet, recognising new assets and liabilities. At present, many analysts adjust financial statements to reflect lease transactions that companies hold off-balance sheet.

new lease accounting standard

The new lease accounting standard[1] published today by the International Accounting Standards Board (the IASB): brings added transparency to the balance sheet, according to KPMG International. 

The new standard requires companies to bring most leases on-balance sheet, recognising new assets and liabilities. At present, many analysts adjust financial statements to reflect lease transactions that companies hold off-balance sheet. 

Commenting on the new standard, Brian O’Donovan, UK partner in KPMG’s International Standards Group, commented: “All companies that lease major assets for use in their business will see an increase in reported assets and liabilities. This will affect a wide variety of sectors, from airlines that lease aircraft to retailers that lease stores. The larger the lease portfolio, the greater the impact on key reporting metrics.” 

Companies are currently required to disclose details of their off-balance sheet leases and analysts use this information to adjust published financial statements. O’Donovan continued: “Current lease accounting requires financial statement users to adjust for off-balance-sheet leases. The key change will be the increase in transparency and comparability. For the first time, analysts will be able to see a company’s own assessment of its lease liabilities, calculated using a prescribed methodology that all companies reporting under IFRS will be required to follow.” 

The impacts are not limited to the balance sheet. There are also changes in accounting over the life of the lease. In particular, companies will now recognise a front-loaded pattern of expense for most leases, even when they pay constant annual rentals. And the new requirements introduce a stark dividing line between leases and service contracts – the former will be brought on-balance sheet, while service contracts will remain off-balance sheet. 

The new standard takes effect in January 2019. Before that, companies will need to gather significant additional data about their leases, and make new estimates and calculations that will need to be updated periodically. O’Donovan continued: “The new requirements are less complex and less costly to apply than the IASB’s earlier proposals. However, there will still be a compliance cost. For some companies, a key challenge will be gathering the required data. For others, more judgemental issues will dominate – for example, identifying which transactions contain leases." 

The accounting changes do not affect cash flows directly. However, given the scale of the accounting change, KPMG expects that companies will be keen to understand the size of the lease liabilities arising from transactions they enter into between now and 2019. O’Donovan commented: “No one wants to see accounting drive business behaviours – the tail shouldn’t wag the dog. But if accounting consequences are in the mix when a company is considering a deal, then the mix will change. For example, this standard essentially kills sale-and-leaseback as an off-balance-sheet financing proposition.” 

Some key impacts cannot yet be quantified. O’Donovan continued: “Companies won’t have the full picture until other accounting and regulatory bodies have responded. For example, the new accounting could prompt changes in the tax treatment of leases. And a key question for the financial sector is how the prudential regulators will treat the new assets and liabilities for regulatory capital purposes.” 

The US Financial Accounting Standards Board (the FASB) will publish a new US GAAP standard on lease accounting shortly. Although the IASB and FASB worked together on lease accounting for years, their final standards feature different lessee accounting models. O’Donovan concluded: “It’s ironic that the outcome of this long-running convergence project will be divergence in accounting for common lease types. The new IFRS and US GAAP standards will introduce differences in the profile and presentation of annual lease expense where none currently exist, reducing comparability between the two major accounting frameworks.”

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