New lease accounting rules – how might they affect leasing and salary sacrifice?
New accounting rules have been proposed which cover the treatment of leased assets, seem unlikely at this stage to erode the benefits of leasing company vehicles or acquiring them through salary sacrifice car schemes.
For the last three years, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have been working on a common standard of accounting for all leased assets, including company vehicles.
Several exposure drafts have been published both before and after periods of consultation with interested parties, providing a framework for the new proposals.
However, depending on their individual circumstances, companies are likely to want to continue to acquire their vehicles through leasing or salary sacrifice arrangements as the majority of the benefits that currently exist seem set to remain.
What are the proposed new lease accounting rules?
Historically, finance leases have had to be reported on a company’s balance sheet as they relate to owned assets, but not operating leases which are treated as an expense item in the profit and loss account. However, the new rules being considered would bring all leases on to a company’s balance sheet, with the exception of short term leases of less than 12 months and a few other exclusions.
As a result, companies will need to highlight their indebtedness to their lease provider for leased assets on the balance sheet in their annual report.
This new approach is referred to as the ‘right of use’ approach and differs substantially from today’s standard which is based on an analysis of the risks and rewards inherent in the lease.
Under the ‘right of use’ model, a lessee would need to display the right to use a leased item and its corresponding liability – in this case the finance element of the lease rental – on its balance sheet. For example, if a lease agreement amounts to 36 monthly payments of £350, the indebtedness in year one will be 36 x £350; in year two it will be 24 x £350 and in year three 12 x £350.
This is a major change as, under the current standard, the lessee recognises the leased asset only if acquired via a finance lease, with just a note to the accounts for any operating lease liabilities. It only applies to the finance element as any maintenance element is specifically excluded.
To whom will the new proposals apply?
The proposed lease accounting rules would apply to all publicly quoted companies that report to the standards of the IASB and public sector organisations. Publicly listed companies already have to make a note to the annual report reflecting any operating lease liabilities.
However, most small and medium-sized enterprises currently report to the UK’s generally accepted accounting principles (GAAP) and will be unaffected until UK standards converge with those of the IASB. There is no deadline for this at present.
There has been considerable industry lobbying over the proposed changes given the importance of leasing to the UK economy. Much of this has focused on the need for the new proposals to be straightforward for small businesses to implement, and the fact that they should not detract from leasing as a simple and cost effective product.
The British Vehicle Rental and Leasing Association, the trade body representing the UK car rental and leasing industry, which has led the lobbying anticipates that the new accounting standards will be published in the second half of 2014 and become mandatory in 2017/18, following a four-year transition period.
What might the consequences be?
The new proposals have the potential to affect the key accounting and financial ratios of major companies, such as debt to equity, return on assets, EBITDA* and operating margins. As a result, debt covenants may be affected and may need to be renegotiated.
However, regardless of the proposed changes, companies are likely to want to continue to lease their vehicles as the majority of the existing benefits from leasing will remain.
Leasing allows companies to benefit from spreading a fixed cost over the lease term, provides 50% VAT recovery on the financing of company cars, offers protection against fluctuations in residual values and provides the opportunity to fully outsource fleet operations and services.
The same can also be said for salary sacrifice schemes, which have seen a huge growth in popularity recently and which enable an employer to provide a leased car to all employees for a low cost linked to a comprehensive package of services.
What changes might we see?
The new lease accounting standard proposals could affect the attitudes of companies towards leasing items of property, plant and equipment.
This may in turn drive the leasing industry to produce new products, such as short term leases, that retain the existing benefits of operating leases. Under the new lease accounting proposals, short term leases for a year or less with no renewal option would still qualify for off-balance sheet accounting treatment.
For those businesses sensitive to the changes affecting longer term leases, such shorter term contracts could become more appealing, especially on job-need fleets where vehicle choice is not such an issue.
However, such short term leases could, theoretically, change the economics of the lease transaction and could result in increased risk to the lessor with increased leasing costs.
What might the impact on leasing companies be?
The balance sheet impact for lessors is likely to be of less significance than for lessees, although estimating the residual value of assets and accounting for variable lease payments may prove onerous and require considerable judgement.
The most significant impact for lessors is likely to be the resources required to evaluate existing operating lease contracts, and to develop processes to capture the required information on an on-going basis.
The new proposals may also result in a need for many companies to upgrade or replace their existing accounting systems.
What should companies do next?
The new lease accounting rules proposals will have different implications for different companies depending on a variety of factors such as size, profitability, attitude to risk and ownership of assets and a host of other issues. There are reports coming out of the US that the IASB might be scaling back the scope of their planned changes, but the consensus still seems to be that leased assets WILL ultimately need to be shown on-balance sheet.
The best advice currently is to consult with your accountant and leasing or fleet management provider to decide on the most appropriate course of action for your business going forward.
*EBITDA – earnings before interest, tax, depreciation and amortization