Accounting Headline 7.11 An example of the effect of new accounting standards on existing debt covenants

New accounting standards could trigger debt covenants ALEXANDRA CAIN Companies with large fleets need to look at the real impact on their business, writes Alexandra Cain. A decade after the idea was proposed, its likely a new accounting standard will require businesses to recognise operating leases on balance sheets.

Under existing accounting standards, operating leases are not recorded on balance sheets. Bringing these leases on balance sheet could trigger debt covenants for organisations with a large number of leased vehicles. This is because bringing operating leases on balance sheet could increase a businesss liabilities over and above levels agreed with lenders. Unlike finance lease contracts, under which ownership of the asset is transferred to the lessee at the end of the term, at the end of an operating lease ownership remains with the lessor. Exactly how an operating lease should be recognised on a balance sheet is tricky, given the organisation that takes out the lease does not actually own the asset. The International Accounting Standards Board is expected to re-issue an exposure draft later this year for a standard that deals with recognition of operating leases on balance sheets after it received a flood of responses to its initial proposal. The IASB received 786 responses in relation to the initial exposure drafta huge amount which indicates the significance of what they are proposing. As a result the IASB is reconsidering its exposure draft, which is very unusual,says Deloitte partner Alison White. One detail that needs to be ironed out, says Mark Shying, CPA Australias senior policy adviser, financial reporting, is the treatment of short-term leases. Short-term leases wont be required to be recognised on the balance sheet, but there needs to be clarification about what a short-term lease is, as well as how options to extend short-term leases will be dealt with, he says. HLB Mann Judd partner Simon James says one problem with recognition of operating leases on balance sheets is the recording of assets.

Its easy to see how lease payments would work on the liability side, but its trickier on the asset side, given that the business does not own the asset. Recognising operating leases as assets and liabilities on a balance sheet could trigger bank covenants, James says. White says: We advise companies with multiple vehicle leases to start planning now. They need to be ready for the change by ensuring collation of accurate lease data and they need to consider the impact on lending covenants and the approach to any new debt renegotiations. Greg White, managing director of GE Capitals fleet business, Custom Fleet, the biggest fleet leasing operation in Australia, says his company has been talking to customers. We are working with clients to increase awareness of the proposed changes and to support them through this process, encouraging them to think now about how the changes will impact on their business. Alison White says the IASB has stated that the standards will not be effective before 2015. She expects them to come into effect from 2016.

7.33 Read Accounting Headline 7.11 and then answer the following questions:

(a) Why could the new accounting standard trigger debt covenants (that is, create a technical default)?

(b) Do you think the likelihood that this new accounting standard will be released would already be influencing the leases that companies would be entering?

(c) Do you think that debtholders would prefer that more leases be recognised and disclosed on the balance sheet, or be kept off balance sheet? LO 7.11, 7.12