Background: In August 2010, the IASB issued an exposure draft proposing changes to the current standard on leases. This current standard requires a lease to be classified as either a finance or operating lease. Only finance leases are shown in the balance sheet with an asset (and a liability) to be recognised if the risks and benefits associated with ownership have been transferred. This approach has long been criticised as being inconsistent with the Conceptual Framework’s definition of an asset, which does not require ownership or a comparison to this. The exposure draft proposes that all leases be recognised in the balance sheet.
The new draft lease accounting standard is an overdue reality check for the corporate world but it also exposes the fault-lines in the standard-setting process.
No one can argue against the value of the standard. The existing rules mean that large amounts of liabilities are hidden off balance sheet. And that frankly cannot, particularly in a post-crisis world, be right. If the general public understood these things they would be shocked, in the same way that people going to the theatre to see ‘Enron — The Play’ were shocked.
The old rules were written a long time ago when we had very different ways of looking at the world. Investors now argue that disclosure is not a substitute for good accounting and that all assets and liabilities need to be on the balance sheet. Standard-setters now take a balance sheet view of life. And in this brave new world where we recognise more and more assets and liabilities on balance sheet, including many more intangibles, why would we not be recognising assets for leases that convey the rights to use the leased assets; and the corresponding liabilities to pay for that use? The proposed new rules reflect the way that the accounting world is moving and put all lease assets and liabilities on balance sheet.
The impact of the proposed standard should not be underestimated. Moving all those liabilities onto the balance sheet will inevitably have an effect. We will see lower asset turnover ratios, lower return on capital, and an increase in debt-to-equity ratios, which could have a knock-on effect on borrowing capital or compliance with banking covenants. The figures are vast. Some ball park calculations suggest that we are talking about an estimated £94 billion of leasing liabilities for the top 50 companies in the UK, and a mammoth $1.3 trillion (£843 billion) for public companies in the US. There will be short-term pain but it will result in long-term gain as business realities are more clearly expressed in the financial reporting.
Source: Extract from Veronica Poole, ‘No pain, no gain’, Accountancy Age.25

Note: The new leasing standard IFRS 6/AASB 16 was subsequently issued in 2016.

Questions

1, Consider the definitions of an asset and liability in the Proposed Framework. Would a 5-year lease for land meet these definitions?
2, The extract discusses the fact that these changes reflect the way in which accounting is moving — that is, towards putting all assets and liabilities on the balance sheet. What reasons could there be for this move? Is this consistent with the approach in the Proposed Framework? Given the identified impact on key company ratios, do you believe this approach is justified?