The new accounting treatment for leases will have far-reaching effects on the financial accounting methods of enterprises that are involved in operating leases, and what they disclose in their annual financial statements.
Accountants distinguish between financial leases and operating leases. Financial leases are leases that have to be capitalised. This means the value of the asset and the liability have to be recognised by entering the values on the balance sheet. This is because such a lease is really a purchase with deferred payment terms. The asset becomes the property of the lessee, and the lessor has a lien over the asset in the event of non-payment.
On the other hand, an operating lease is a lease where the ownership does not pass to the lessee, but the rental is paid for the use of the asset for a fixed period.
In the past it has been the practice for an enterprise to charge to its profit and loss account during any accounting period, the actual cash payment due for that period. There have been some exceptions such as balloon payments, but essentially the amount due has been charged to the accounting period based on cash flow.
As most leases have an escalation clause, this means that the amount charged during any single accounting period is the amount of the actual cash paid. This is simple enough, of course, and what any layman would do. However, this is far too simple for accountants. In future, the total amount payable over the whole lease period has to be totalled and divided by the number of accounting periods. The average rent so calculated must then be charged to the profit and loss account, and the difference between the cash paid and the amount charged to the profit and loss account will appear on the balance sheet as a liability.
This treatment also impacts the tax accounting and affected enterprises will have to disclose that impact through an adjustment to its deferred tax asset account that must appear on the balance sheet.
I have resisted the temptation to give my opinion for free on this, but it`s actually not as much nonsense as it seems. Large enterprises need to account in the same way, otherwise third parties will not be able to understand or compare balance sheets. While this may not make sense to smaller companies, there is a case for standard treatment. Enough said.
Of course, it is not as simple as I have just explained. Nothing ever is.
The new accounting treatment applies to operating leases with fixed escalations only.
This means that operating leases that depend on CPIX % or turnover or that cannot be calculated in advance, will still account the old way.
The prior financial statements will have to be restated so the impact of the change can be disclosed.
The requirement to show in the form of a note to the balance sheet, the outstanding amounts due over the whole period of the lease remains.
All this means a huge amount of work for enterprises with many operating leases, such as retailers. There will also be a significant change in the financial statements that could affect share prices as well.
In the long run it will all even out, but the initial impact could be quite traumatic for some companies.
At Realyst we have given this much thought and have already developed a module to our contract management software that will generate the necessary reports for the financial teams of our clients.
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