No pain, no gain

The new draft lease accounting standard is an overdue reality check for the corporate world but it also exposes the fault-lines in the standard-setting process.

No one can argue against the value of the standard. The existing rules mean that large amounts of liabilities are hidden off balance sheet. And that frankly cannot, particularly in a post-crisis world, be right. If the general public understood these things they would be shocked, in the same way that people going to the theatre to see ‘Enron – The Play’ were shocked.

The old rules were written a long time ago when we had very different ways of looking at the world. Investors now argue that disclosure is not a substitute for good accounting and that all assets and liabilities need to be on the balance sheet. Standard-setters now take a balance sheet view of life. And in this brave new world where we recognise more and more assets and liabilities on balance sheet, including many more intangibles, why would we not be recognising assets for leases that convey the rights to use the leased assets; and the corresponding liabilities to pay for that use? The proposed new rules reflect the way that the accounting world is moving and put all lease assets and liabilities on balance sheet.

The impact of the proposed standard should not be underestimated. Moving all those liabilities onto the balance sheet will inevitably have an effect. We will see lower asset turnover ratios, lower return on capital, and an increase in debt-to-equity ratios, which could have a knock-on effect on borrowing capital or compliance with banking covenants. The figures are vast. Some ball park calculations suggest that we are talking about an estimated £94bn of leasing liabilities for the top 50 companies in the UK, and a mammoth $1.3 trillion (£843bn) for public companies in the US. There will be short-term pain but it will result in long-term gain as business realities are more clearly expressed in the financial reporting.

On the other hand, is all this really necessary now? Preparers point out that figures for operating leases are already shown in the notes to the accounts and that they and the credit ratings agencies already factor the figures in. They also argue that the new proposals will create unnecessary complexity, estimation uncertainty and subjectivity, particularly in respect of renewal options and contingent rentals. As well as all this, are we not bringing in questionable rules on lessor accounting in the name of convergence between FASB and the IASB? The lessor accounting “solution” had not been previously debated or field tested. It is a compromise between the IASB and FASB that ends up with two new models and a new dividing line. Convergence is important, but not if
it results in rushing through a compromise for political expediency, particularly at the time when many other standards need urgent work.

The draft lease accounting standard is open for comment until 15 December 2010.

Veronica Poole is head of Deloitte’s global IFRS leadership team