It has become an increasingly popular topic of conversation that accounting rules for the leasing of assets is about to change.
Accountants need to pay particular attention to leases in deciding whether or not a particular agreement needs to be identified on a company’s balance sheet. In doing so they will be operating under nationally and/or internationally agreed accounting procedures. A balance sheet is part of a company’s annual accounts which identifies assets owned by the business and liabilities due in the future. The treatment of leases can become something of a grey area because what appears to be the same type of agreement may or may not have to be shown on a balance sheet.
The accounting practices currently adopted by UK businesses are covered within an accounting rule called IAS17 which recognises two types of lease:
A finance lease is one in which the risks and rewards of ownership are deemed to have been passed from a leasing company to a lessee (user) and will include all credit agreements (hire purchase) and any other agreement where the term of hire covers the economic life of the equipment and the sum of all rentals payable equate to most or all of the cost of buying the asset concerned. Such agreements have to be shown on a balance sheet with the asset value identified and properly depreciated and all future rental payments shown as liabilities.
However, certain hire agreements can be classified as operating leases. This will be the case where the length of an agreement is shorter than the economic life of the asset and the rentals payable are substantially less than the cost of purchasing the asset. Accountants use their own formulae to decide qualification. There must also be no option for the user to acquire title at any time. Under IAS17 such leasing agreements do not need to appear within a balance sheet and therefore anyone analysing a set of accounts will have no easy way of ascertaining the true asset v liability position of the company concerned. The only basis on which a leasing company can offer an agreement where the sum of the rental payments is less than the purchase price of the asset is where:
- The asset being financed has significant resale value at the end of an agreement.
- The resale value (or residual amount) is recognised by a leasing company as the amount at which it will sell the asset at the end of an agreement, thus enabling the offer of discounted rental payments during the period of hire.
Much reference has been made in recent months to changes in the way in which leases are treated from an accountancy perspective. Such references involve the introduction of a new internationally agreed accountancy standard (IFRS16). Companies using IFRS16 will have to account for nearly all of their leases (including operating lease) ‘on balance sheet’ from January 2019. For some industries the sudden appearance of new assets and liabilities will make certain accounting ratios look very different, with both positive and negative implications. These implications have led to questions being raised as to whether businesses will change the way in which they acquire capital equipment.
The first point to make clear is that the only organisations which will need to adopt IFRS16 on 1 January 2019 are in the main represented by companies that are publically quoted and their subsidiaries, similar changes will also apply to companies currently using USGAAP, but the vast majority of organisations in the UK will not be affected. Secondly, and to repeat, any agreements currently classified as finance leases, including hire purchase, are not affected since they are already ‘on balance sheet’.
Even for those larger companies who will need to change the way they account for leases, it is worth noting that only certain sectors will be significantly affected and these will be businesses where leased assets (currently off balance sheet) are of disproportionate significance. Two such assets are property and aircraft and therefore the industries which will face the biggest change in the appearance of their accounts from next January include retail, leisure and airlines.
For those businesses that currently apply IAS17 but will be changing to IFRS16 next year, there appears to be little reason to move away from operating leases as a method of acquiring use of assets. Whilst ‘off balance sheet’ funding may (or may not) be appealing there are many other powerful reasons why operating leases will remain attractive:
- Effective and easy source of funding
- Maintenance and services included within the finance package
- Improved cash flow
- Predictable monthly payments
- Removal of asset and disposal risks
- Flexibility of use
The points raised above are a very general summary of a complex subject so it is important that any organisation contacts their own financial advisors to get clarification relating to their own specific circumstances.
Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.
If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.