Businesses unprepared for impact of new accounting standards

6 October 2011

Leasing Survey shows many Businesses unprepared for impact of new accounting standards

KPMG published their Leasing Survey Report today which canvassed over 300 businesses who operate with leased assets or provide leased equipment to clients. The Survey Report provides insight into how these organisations view the impact of proposed new accounting standards on leasing on their own and their customers’ businesses.

“Since 2010 companies have had the opportunity to assess the impact these proposed new standards will have on balance sheet reporting, and in particular the impact this will have on income, solvency ratios, and bank covenants. Our survey shows that although awareness of the proposed changes is high, companies have been slow to assess the impact to their business and make plans to address any negative effects this will make on their financial statements. We strongly advise that companies, particularly those with a large proportion of leased equipment or premises, or have leases of high value, make immediate plans to address the impact of the new standards before compliance comes into effect, expected within the next four years,” says Simon Lee, National Technical Director, Accounting Advisory Services, KPMG.

The proposed new accounting standards are being issued in response to long standing criticisms that current lease accounting is too permissive of off-balance sheet accounting by lessees and dominated by a plethora of rules. Authors of the proposed new standards, the International Accounting Standards Board (‘IASB’) together with the US Financial Accounting Standards Board (‘FASB’) issued their initial Exposure Draft Leases in August 2010 with a re-exposure expected in quarter four of 2011. Their proposals will radically alter the way that leases are accounted for by both lessees and lessors.

While the IASB/FASB report that the changes are being met with support by users of financial statements, KPMG’s survey highlights that many New Zealand companies are unhappy about the proposed impact of the changes on their financial statements.

In essence, the proposed changes to lease accounting standards by the IASB/FASB are:

• For lessees, all leased assets will appear on the balance sheet of companies as a right-of-use asset. The corresponding liability represents the obligation to make lease payments to the lessor.
• For lessors, a residual asset is recognised which represents the right to the asset at the end of the lease term. The lessor also recognises a receivable for the payments from the lessee.

The objective of the proposed changes is to provide consistency in accounting for lease arrangements and remove the distinction between operating and finance leases. This will remove off-balance sheet financing of assets and address differences in accounting ratios and promote a “level playing field” for all company balance sheet reporting.

Impact to Business
There are three key areas which will be significantly impacted by the proposed changes:
1. The major impact of the proposed standard is on companies that are currently using operating leases as a way of financing assets used in the business. Currently, the accounting standard requires an expense to be charged in the income statement for the asset rentals. However, under the proposed leasing standard, all lease agreements will result in lease assets and lease liabilities being recognised in the accounts. In KPMG’S survey, 61% of respondents held only operating leases with a further 20% holding primarily operating leases. This is going to have a significant impact on the balance sheets of a large number of New Zealand companies.

2. Reporting of profitability will change, in particular, for entities that currently hold operating leases. Operating lease rentals are currently recognised as an operating expense. Under the proposed standard, expenses charged to the income statement will be interest on the lease liability as well as depreciation on the lease asset. For organisations that use EBITDA as a performance measure (earnings before interest, tax, depreciation and amortisation) the interest and depreciation will not be included in EBITDA whereas previously the operating lease rentals would have been. This will have the effect of increasing EBITDA and potentially affect measures that use EBITDA as a basis, such as bonus schemes.

3. Bank covenant agreements may be breached as a result of recognising further liabilities on the balance sheet or additional interest expenses in the income statement.

KPMG Lease Survey Highlights
Conducted in July 2011, the KPMG Lease Survey sought to gauge awareness of the proposals set by the IASB/FASB and the perceived impact of the changes on New Zealand entities.

• Over 300 responses, including detailed comments that provided insight into how organisations view the impact of the proposed standard and how it may affect their businesses.
• Only one quarter of respondents have assessed the impact on their business at this point in time.
• Over half of respondents believe that the changes will have a significant impact on financial reporting. Businesses with high numbers of operating leases will initially find that there will be a great deal of work to be done to apply the standard.
• Most respondents felt that there would be little impact on arrangements with banks or other lenders, credit rating agencies or tax authorities. However for some entities, there will be a serious impact on bank covenants and which will need to be considered well in advance of the changes coming into effect.
• The majority of respondents did not think the costs of adopting the standard will be high and that they have the technical skills to deal with the changes. However, for businesses that have a large number of leases, there is likely to be a significant initial cost in terms of the amount of work required to implement the processes for recording and accounting for leases. Some smaller businesses may not have the technical skills and will need to outsource this work.
• However, at this point in the process, the majority of respondents do not anticipate changing their business decisions as a result of the proposed changes in financial reporting.

“Our Survey respondents showed they have very strong feelings about the proposed new leasing standard. However, the IASB has consulted extensively in developing the proposals and are committed to the implementation of a new lease standard. It is, I believe very unlikely that the IASB will abandon or significantly change its views on the project at this late stage,” says Mr Lee.

Next Steps
The revised Exposure Draft from the IASB is expected in the last quarter of 2011 and the new IFRS is expected in the second half of 2012, with the effective date of the new accounting standard not expected to be before 2015.

“In the meantime, lessees should consider the impact on their financial statements of having to recognise a right-of-use asset and a lease liability. If it causes a problem with bank covenants, solvency tests or ratios based on EBITDA, then there is still plenty of time to take action before compliance is mandatory.

“For lessors, the accounting model for lease agreements will change with the recognition of a residual asset as well as a lease receivable. Additionally, customers may require guidance on how to account for their lease agreements under the new standard,” says Mr Lee.

Future Surveys
KPMG plan to repeat the Leasing Survey again in 2012 so that assessment can be made on how perceptions have changed once the final Exposure Draft is issued.

A copy of the Leasing Survey can be downloaded here Leasing survey 2011 results

ENDS

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