Accounting For Leases by Lessors Essay

This report is a document that is outlining the critical evaluation of the proposed leasing standard which the IASB / FASB are trying to introduce. IASB stands for International Accounting Standards Board, and is the international accounting standard adhered by UK and European companies. FASB stands for Financial Accounting Standards Board and is used in the US as a generally accepted accounting principle (GAAP). After the Enron scandal a project has been set up to combine the FASB and IASB so that companies can have more clarity on how to account for certain transactions internationally but more importantly to have a single standard that is used across the board, therefore can be used interchangeably by different economies.

At the moment UK companies who trade in the US adhere to a principle called SOX (Sarbanes Oxley) to comply with the US GAAP accounting rules. The Sarbanes-Oxley Act of 2002 is mandatory to ALL US or US affiliated organization. The Sarbanes-Oxley Act is arranged into eleven titles. As far as compliance is concerned, the most important sections within these are often considered to be 302, 401, 404, 409, 802 and 906. These are the over-arching rules that a public company accounting board have established by the act and was introduced amidst a host of publicity major corporate and accounting scandals including the likes of Enron, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation’s securities markets.(*1)

The report will outline the issues raised by the new lease standard and its effects on the preparers of accounts and the consequential effect on the final financial statements which stakeholders and potential investors use to determine the successful nature of the business. The report will focus on the retail sector, in particular the supermarkets as an example of the kinds of issues and debates arising. It will then conclude with the overall impression and practicality of the standard using the evidence mentioned in the report.

In the “Tesco and Sainsbury’s attack lease accounting proposals” (*2)article there is a mistake, the article talks about lease contracts going on the balance sheet as a “asset or liability” when it should say “assets and liabilities”. This could be debated though in the case of a future liability, known as a contingent liability to the company, however the report will discuss this issue later. The proposal of the new lease standard states the lessee should apply a single accounting approach for all leases and would require a lessee to:

* Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.

* Subsequently measure the liability to make lease payments using the effective interest method.

* Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits

(Financial accounting standard board 15.11.11) *3

This is known as the IASB17 leasing standard. The standard states that the asset leased would go into the lessee balance sheet as an asset at fair value or at the net present value (NPV) of leasing payments, whichever is lower. Fair value is the amount for which an asset could be exchanged for between knowledgeable and willing parties. The asset should firstly be depreciated at the same rate as other assets on the lessee’s balance sheet. Thereafter depreciated in a method that best mirrors the economic benefit gained in the future from using the asset. The liability would be the lease repayments due in each financial period. This would mean that all leases would be treated in future as a financial lease. Currently the accounting treatment of leases depends on the kind of lease obtained. There are two kinds of leases A) Financial lease and B) Operating lease. As mentioned above financial lease involves the lessee stating the lease as an asset and liability in their balance sheet, however if you lease as an Operating lease then you would not have to declare a figure in your balance sheet. This current treatment is allowing managers to use creative accounting and manipulate their accounts so the business looks more profitable and hence more investable. The issue can be highlighted by an example,

company A buys an asset for the use of its company. So it will have to state it as an asset in its balance sheet and then amortise it annually. But company B who are similar to company A chooses to lease the asset as an operating lease instead of buying the asset. Now although both companies could be off similar business strength and wealth their balance sheet would look different, and company B would look better to invest in due to the asset and the liabilities attached to the asset being of the balance sheet. Would this be fair? Hence under the new proposal both operating and finance leases would have to be stated in the balance sheet meaning in this case there would be no difference in the companies balance sheets thereby giving a more “true and fair” view.

The effects of these new standards have caused great debates amongst the retail sector and professionals. The issue is quite major as the global leasing asset is valued at 765.8bn of which operating assets are �440 million in rental costs of the FTSE 50. To put this into perspective this is 21 times the UK defence budget figure. The main argument is that the bigger companies have a lot of their major lease costs tied up in their fixed assets. The first problem here is the word “global”. This means worldwide and as mentioned at the start of this report different countries have different GAAP’s therefore it would imply that their valuation of transactions would be different, consequently collecting all the valuations and merging them together wouldn’t be entirely a “true and fair view” of the valuation. The second issue being the rental costs would now be going into the balance sheet and being rewritten off on a yearly basis in the income statement. This method under the new standard would have a number of implications of which one is “pre tax profits would decrease by 25%” (Top four major accounting firms).This would show the firm is suddenly less profitable from the year before the standard was picked up to the year the standard was applied.

On the balance sheet side the addition of more assets and liabilities could be harmful as the balance equation would change. This change would affect a number of investment ratios that investors such as banks and shareholders use to determine how stable and profitable the company is. One of these key ratios is the debt to equity ratio and this would decrease under the possible standard, making the business more geared and looking like a bad investment. Also the Return on Capital Employed (ROCE) ratio would decrease resulting in the loss of investors. The asset turnover figure would increase though.

This would give a confusing picture to investors as on the one hand asset turnover has increased making it sound good as it shows the business is expanding and investing in new assets though it reflects the business is highly geared and in debt. The combination is not a great one as it appears that the business is borrowing on credit and may be biting more than it can chew. As a result investors and shareholders would be less inclined to invest in them, hence revenue streams would decrease. The major problem would be as the debt ratio increases the banks would be less inclined to lend, causing a strain on the incoming investment funds. It could be therefore argued, how would the new standard be more beneficial? It may show stakeholders more details into the businesses financing and funds but at the expense of the business, which may cause a lot of companies to go into bankruptcy due to their funding levels decreasing and hence equity going into the red.

In the article, Tesco states that the new standard would “confuse the investor” and Sainsbury says it “will replace an imperfect model with another imperfect one”. This is backed up by research that was carried out by Grant Thornton. They surveyed 2,800 business and more than “54% didn’t know that all but short term leases” (Grant Thornton research) *4, would be placed onto the balance sheet, however 46% were in favour of the new standard of which 14% said it brought more transparency and help users of accounts. This is as expected as the market will take time to understand and react to new standards and as a result you do get temporary inefficiency in the market causing the complexity and confusion, this is called a time lag. Though one would say the 46% in favour would be mostly SMEs as the change wouldn’t affect their accounts much, though it would be very hard to see the larger companies agreeing with this view as their asset value and liability would dramatically change, with the majority of their leases being fixed assets.

But there could be an argument saying that if more than 54% were unclear what the new proposal meant, it couldn’t be that transparent and clear. But it could also be the case that that there may be a group of individuals who are thinking of lobbying the standard as it is relatively new, in which case if majority didn’t comply with the standard, the minority would stop using it. This would mean that the principle would be unenforceable and if society and majority were to pass the principle away the principle would be of no use and just on the shelf. As a result the IASB would be back to square one with an imperfect system. Though on the other hand one could say that the IASB would be able to force the principle through due to any new legislation which helps users make an informed view with more transparent and detailed information is of good use and will paint a “true and fair” view of what the business in question is like. But the question is, of all the users of the accounts how many can actually understand and interpret the meaning of the accounts and their implications? So one could say the issue lays with the understandability of the accounts not the transparency.

Another issue which comes straight to mind when reading this article is that Tesco is an international company. The likes of them being in countries such as China and India would make the accounting treatments of their assets more difficult to value and treat their assets in their annual accounts. The main reason being that these countries have their own accounting rules and principles which are not enforced by IASB or UK/ US GAAP. They therefore would have to use the exchange rate to bring the valuation into pound sterling, so they can incorporate the figure into their annual published accounts. Such methods would then make the word “true and fair” loose, as conversions would bring inconsistencies and financial distortion into the published accounts. Also with such methods one could be host to several problems including “holding gains and losses”.

Holding gains and losses result from changes in the prices of assets. They occur on financial and non-financial asset and liabilities. Holding gains and losses are accrued to the owners of assets and liabilities purely as a result of holding the assets or liabilities over time, without transforming them in any way. In Tesco’s case this could take place when having a lease on premises aboard, so when they initially lease the building the fair value of the asset is (x) amount after they have exchanged it into pound sterling. But then later on in the year when they have to put the value again into the balance sheet the exchange rate could have changed, therefore raising a holding gain or loss. This increase or loss of equity would have an effect on the balance sheet but how would one state the adjustment? One way could be to impair the asset and therefore revalue the asset again, so the extra value is written off as a cost. In doing such methods one would be using IAS 36 (Impairment of Asset) and IAS 16 (Property, plant and equipment).

IAS16 states that assets of a company should be revaluated regularly so the carrying amount doesn’t differ from the fair value of asset at the balance sheet date. Also when revaluating the asset, all other assets that are linked to the asset in question also have to be revaluated under this model, all are then depreciated. If the revaluation results in an increase of value then it should be credited to the income account and accumulated under the heading “Revaluation surplus” in the equity account. If the revaluation results in a decrease in value then result should be recognised as an expense. When an asset is disposed of any surplus is transferred to retained earnings or left in equity under “revaluation surplus”. (IAS Plus *5)

However for Sainsbury the IAS 40 (Investment property) would be more relevant. The reason being is that 90% of their lease costs relate to building and property. IAS 40 states if a property is held by a lessee under a lease it may be accounted as an investment property provided that:

* the rest of the definition of investment property is met

* the lease is accounted for in accordance with IAS 17

* the lessee uses the fair value model

(IAS Plus *6)

This now brings about a totally new debate and potentially creates a new problem called “sub leasing”. If Sainsbury were to lease a medium size property for their new store in a new town, they would then have to change the property slightly in order to make it compatible to a supermarket store. This would show that the property has been modified for the use of trading which therefore inherits substantially all the risks and rewards to ownership of the asset. This would mean that the lease would act as if it is a finance lease and treat the asset as if it was brought by them. Say the term of the lease was ten years, but after five years the demand of the store lessens, the store would be then thinking of moving to another location but the term for the property is ten years so it still has some years left.

Plus a leasing agreement is non cancellable therefore they would have no scope to come out of the agreement or pay a fine to come out of the contract. But as they have taken on all the risks and rewards could they act as if they own the property and lease it out to another company for the remaining years. How would you deal with this transaction in the accounts of Sainsbury’s, and would the lessor allow this transaction to happen? The proposal board are currently trying to resolve this matter and at the moment the boards are in agreement with accounting professionals that head lease and corresponding subleases would be accounted for as separate transactions. The subleases would be accounted for in accordance with the lessee and lessor accounting models, with the intermediate lessors having to evaluate the right-of-use asset recognised under the “head lease” instead of the underlying asset, to distinguish lease classification.(IAS Plus *7)

This sort of transaction is when the asset goes from being in a lease agreement to becoming a fixed asset in the company’s accounts due to the risks and rewards being inherited creating a term called a “Contingent Liability” which is defined in the principle IAS 37 ( Provision, contingent liabilities and contingent assets). This defines a Contingent Liability as “a possible obligation depending on whether some uncertain future event occurs or a present obligation but payment is not probable or the amount cannot be measured reliably”. (IAS Plus*8)

This would happen in the case of Sainsbury as when they change the property to their needs they would inherit the risks and rewards, but in doing so they also inherit the liabilities associated with the asset in the forms of maintenance costs and insurance etc. This would be a contingent liability as the costs would be of future liability and will mature when they sub lease and they become the lessor. So as mentioned at the start of the report the argument of Asset or liability would come into play as in this form of transaction it was an asset but now a liability NOT both at the same time.

Another issue that could be linked to subleasing or of similar relevance is “sale and leaseback agreements”. This is where a company may be in financial difficulty or short of cash, so what they can do is to sell an asset to generate cash and then lease the asset back with an agreement. This is beneficial in two ways, the first as mentioned above generating cash in hard times and the second removing all risks attached with the asset. These risks would involve things like insurance and maintenance, as these would be transferred to the owner of the asset. The treatment however would depend on what kind of lease it would be. If it was a short term lease then it wouldn’t have to be declared on the balance sheet, though if it was of any other lease then the treatment would be in accordance with IASB 17.

Therefore there would have to be an asset and liability transaction in the balance sheet. But this is where an issue of creative accounting could arise and companies could try and use the loop holes to obtain off balance sheet finance so they wouldn’t affect their balance sheet equation. One example of such a transaction is to sell an asset but having an agreement that in the future the company can repurchase the asset back. This way they are obtaining funds they need by selling the asset but have the advantage of getting the asset back, meaning the asset is not on their accounts so wouldn’t hurt their balance sheet equation. However there is an IAS called IAS 18 (Revenue recognition) to try and stop this from happening. This deems that such transactions are not deemed to be a sale as the risks stays with the first company and as a result is called “bed and breakfast financing”. Also IFRS 7 (Financial Instruments) helps such transactions not occurring.

As you can see the new standard has come about to try and make the accounting treatment for companies with leases more transparent and clear. It is so the users of these accounts can have a more broader picture of what the accounts in question are really like and how they are operating, plus with what risk and funding. Though as this report suggests there are also a lot topical debates attached with this new standard, hence the IASB board are continually reviewing and updating the small print of the standard to iron out any teething problems that the associated professionals have brought to their attention. In my opinion this standard is needed as the underlining aim of the board is to make companies show a true and fair view in their accounts. At the moment this is not totally happening as even though there are IAS’s to stop off balance sheet funding and “creative accounting”, companies can still make their accounts look better compared to others. An example of this would be operating leases which before weren’t shown on the balance sheet so as mentioned in the report would be unfair on companies who bought or used a finance lease.

The report in my opinion is not a good insight of the standard not working as there is not enough evidence to support this as taking a two firm view both of which are in the same market sector doesn’t give the consensus of the whole market or other markets. This is because different companies would have different strategies and as a result the IASB 17 leasing standard would affect them in different ways. This can be demonstrated as in the article Sainsbury is affected by the standard through their high property linked to leasing, whereas Tesco would be affected through them being worldwide and as a result having to convert accounts from foreign currencies into pound sterling which gives impairments if exchange rates change from initial valuations. To get a better view I would suggest a market research poll like the one Grant Thornton did again but in some year’s time. I think this would be needed as they did one straight away, this from past experiences and theory suggest it is a bad idea and you wouldn’t get a true picture of the standards effects.

The main reason for this would be that markets aren’t totally efficient, therefore if you were to bring a new idea or standard onto the table the market would need time firstly to understand the standard and its implications, and secondly the standard would need time to adjust its self to the market and get rid of the teething problems. These problems at the start would give rise to market inefficiency and at first will show that the standard is not working. Also alongside this point you get the problem that humans are resistant to change, so therefore will try anything to show the standard is not working to avoid the extra work in changing to the new way. You will get this resistance as shown by the report; this change will bring all but short term leases onto the balance sheet and will change their balance sheet in a big way.

Also investment lending till the market accepts the new standard will bring a different accepted investment ratio level. However if one was to do this survey after a number years have gone by and both market plus companies have adjusted and understood the standard change, one would get a better idea on how the change in standard has affected the transparency and the ability to stop creative accounting. Overall in regards to Tesco and Sainsbury, both have valid arguments for rejecting the new standards, however it will be some time before the affect of the new proposed standard will be seen on the balance sheet, and in turn the bottom line figure of these 2 organisations.

Referencing Page

*1

http://www.sarbanes-oxley-forum.com/

*2

http://www.accountancyage.com/aa/news/1934865/tesco-sainsburys-attack-lease-accounting-proposals

*3 http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011123#summary

*4

http://www.accountancyage.com/aa/news/2121299/lease-accounting-changes-little

*5

http://www.iasplus.com/standard/ias16.htm

*6

http://www.iasplus.com/standard/ias40.htm

*7

http://www.iasplus.com/agenda/leases.htm

*8

http://www.iasplus.com/standard/ias37.htm

Other sources for information

* http://www.accountancyage.com/aa/news/1809151/lease-proposals-add-gbp60bn-books

(Adding to books hence 25% decrease in profit)

* http://www.accountancyage.com/aa/news/1933143/lease-rules-add-gbp737bn-ftse-100-balnce-sheets

(FTSE 100)

* International Financial Reporting And Analysis, 3rd edition, Alexander Britton and Jorissen.

* Financial Accounting An International Introduction,4th Edition, David Alexander and Christopher Nobes

* Lecture notes.