In January, 2013, international financial reporting standards will change the basis of accounting for leases, by no longer recognising "operating leases". The source of the balance sheet confusion stems from the recognition for accounting purposes of two types of leases - operating and finance leases.
Two different companies with the same type of leases would have completely different balance sheet accounting for them. Furthermore, two companies, both party to a single transaction (as lessee and lessor), could have different accounting one showing it as an asset without the other accounting for it as a liability. Obviously, the IASB did not like this and decided to fix the problem by getting rid of the difference between financial and operating leases. From 2013 on, everything will be a finance lease.
In preparation, companies should consider carefully making changes to their legal documents in the wake of a new accounting standard, IAS 17, which stands to affect hundreds of thousands, if not millions, of lease agreements. In the case of long-term inter-company leases, companies should look immediately at cancelling them and entering into one-year leases to avoid the new accounting treatment, which could be detrimental to the strength of their balance sheet, as well as having a significant tax consequence.
Unlike most accounting standards, which affect only accountants and auditors, the impact of this standard will certainly affect the drafting of leases, many of which will require amending to avoid actual financial loss.
This means that in respect of all leases, it will in future be a finance lease and will have to be reflected on the balance sheet as an asset or a liability, depending on whether one is the lessor or lessee. This is not just for property leases, but for every leased computer, fax and photocopier machine, or any other asset with a lease term longer than one year.
This means that businesses will have to take every lease they have and capitalise it, not only from 1 January, 2013, but with a restating of accounts for the past two financial periods.
For the lessee, this has the consequence that it will have many assets on its balance sheet that it does not legally own. Finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset, and the present value of the minimum lease payments.
At commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the nett investment in the lease.
This has huge deferred tax implications. In the past, if you had a five-year lease it would be regarded as an operating lease because there was no risk or reward attached to the transaction. Now, the asset or liability will have to be present, valued and disclosed.
In this case, now is the time to look at restructuring inter-company leases by cancelling them and entering into one-year leases to avoid this accounting treatment.
