There will be much change in lease accounting from 2019. From 1 January 2019, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) will implement new standards, ASC 842 and IFRS 16 respectively. What actually is lease accounting? And what exactly is going to change?
What exactly does lease accounting involve?
Buildings, land, cars or other assets can be rented. Whereas it used to be the norm that organisations bought everything, from premises to photocopiers, the capital expenditure or the long-term financing needed for this approach was one of the reasons that organisations grew slowly. In addition, from a financial perspective an owned asset was not very flexible.
In the 1980s and 90s the trend changed towards renting rather than buying and this was for a number of reasons. It meant that organisations no longer needed to save or take out a bank loan, but rather they could simply lease what they needed. The money which was released as a result could then be invested in their core business, for example, by hiring new staff and thereby developing profitable workstreams. This delivered more profit than the annual returns from purchased premises. The name that is given to this is ‘off-balance financing’; companies no longer had major debts and assets on their balance sheets, but rather they financed through sale and leaseback.
However, shareholders and accountants then felt the need for clarity and realistic figures. The accountancy world decided therefore that a multi-year rental obligation (or lease) should in fact be regarded as a debt, and should therefore be reflected as such in the balance sheet. When a leasing contract is included on one side of the balance sheet, the right to use the premises should appear on the other side. This gives shareholders and accountants far better insight into the actual value and debts of an organisation. This is the principle of lease accounting.
What will change from 1 January 2019?
With effect from 1 January 2019, publicly listed companies will be required to include on their balance sheets all leasing contracts with a contract term longer than one year. This process was launched a few years ago by the FASB and the IASB, both of which are bodies with the authority to define standards that organisations have to adhere to. In recent years, more than a thousand proposed amendments to these new standards have been proposed and this is why it has taken some time for the final versions to come into force. The result, however, is that the new standards have had good input from finance professionals. The outcome is that from 1 January 2019, publicly listed companies will have to list not just their lease contracts on the balance sheet, but also the way in which both the obligation to pay rent and ‘ownership’ of the right to use the asset will be calculated and regularly reported.
This will not, however, make leasing less attractive to organisations, given that the principle remains unchanged: buying buildings produces a meagre return (3 to 4 per cent). Although a rental contract is currently shown on the balance sheet as a debt, the money thus released continues to be available to invest in the core business. The margins on production are often far greater, enabling an organisation to increase its profit. The new standard simply gives a more honest picture of an organisation’s financial situation.
The new lease accounting standards will not only impact operational management, but they also offer new opportunities. I will elaborate on this in my next blog.