Leasing

In an address entitled 'Introductory comments to the European Parliament' (made in Brussels, Belgium) on 11 January 2016, the Chairperson of the IASB, Hans Hoogervorst, made the following comments in relation to the new accounting standard on accounting for leases (as reported 11 January 2016 on the IASB website at www.ifrs.org):

I would like to make some comments about our upcoming Leases Standard, which we will publish the day after tomorrow. Currently, listed companies around the world have around 3 trillion euros' worth of leases, especially in sectors such as the airline industry, retail and shipping. Under current accounting requirements, over 85 per cent of these leases are labelled as operating leases and are not recorded on the balance sheet. Clearly, the accounting today does not reflect economic reality. Despite operating leases being off balance sheet, there can be no doubt that they create real liabilities. During the financial crisis, some major retail chains went bankrupt because they were unable to adjust quickly to the new economic reality. They had significant long-term operating lease commitments on their stores, and yet had deceptively lean balance sheets. In fact, their off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet. Moreover, the current accounting for leases leads to a lack of comparability. An airline that leases most of its aircraft fleet looks very different from its competitor that bought most of its fleet, even when in reality their financing obligations may be very similar. There is no level playing field between these companies. These problems will be resolved in the upcoming Leases Standard. All leases will be recognised as assets and liabilities by lessees. The accounting will better reflect the underlying economics. This change is expected to affect roughly half of all listed companies and will not be popular with everyone. Accounting changes are often controversial and can be met with warnings of adverse economic effects and costs of system changes. The IASB has looked at all these possible risks very carefully and we will publish a detailed effect analysis on the Standard. Our conclusion is that the risks and costs of the new Leases Standard are manageable. First of all, IFRS 16 will not put the leasing industry out of business. Leases will remain attractive as a flexible source of finance. It will remain appealing to companies to lease assets so that they do not bear the risks of owning them. While the cosmetic accounting benefits of leasing will disappear, the real business benefits of leasing will not change as a result of the new Standard. We do not deny there will be costs involved in updating systems to implement the new Leases Standard, but we have done our best to keep these costs to a minimum. For example, we are not requiring companies to recognise assets and liabilities for short term and small ticket leases. This should be especially beneficial for smaller companies. In sum, we expect the benefits of the new Leases Standard to greatly outweigh its costs. The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management. IFRS 16 will lead to improved capital allocation, which should be beneficial for economic growth.

1. Explain why the Chairperson of the IASB believes that the former accounting standard for leases did 'not reflect economic reality'. (4 marks) 2.What is the reason why, under the former accounting standard, reporting entities' 'off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet'? (4 marks) 3.Why does the Chairperson of the IASB argue that under the former accounting standard for leases there was 'no level playing field' between some airline companies? (4 marks) 4.Why do you think the Chairperson of the IASB said that the new accounting standard for leases 'will not be popular with everyone'? What would cause this unpopularity? (4 marks) 5. What are some of the possible reasons why the Chairperson of the IASB would say: 'The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced leaseversus-buy decisions by management'? (4 marks)