Since its increasing occurrence during the late 1960s, leasing was not just used as a financing alternative, but also as a measure to influence financial statements and key performance indicators. In particular, the airline industry was famous for taking almost all of their fleet off-balance. But also Swiss banks and Swiss companies were involved in structuring and using leasing transactions. Since then, financial statement users (professional analysts in particular) struggled to compare companies which heavily made use of operating lease models, with those who financed their property, plant and equipment with traditional debt instruments. Taking a large portion of the invested capital and the related debt off the balance sheet through operating lease transactions, positively influences key performance indicators like turnover rates, asset return rates and gearing ratios.
The new leasing standard aims to overcome this incomparability by replacing the current “all or nothing” approach with the recognition of a “right of use” asset, hence taking more or less all leases on balance in the lessee’s financial statements. This “financial reporting revolution” affects banks in three ways: firstly as preparers of financial statements, secondly as users of their client’s financial statements in investment and credit decisions and thirdly as lessors in property and equipment lease arrangements.
The most important things to know
The core of the new requirements mean that leasees have to take almost all leases, with some cost-benefit driven exceptions on balance. The leasee has to recognise a right of use asset, measured at the lease liability at initial recognition. The lease liability is measured by discounting the future lease payments with the rate “implicit” in the lease, if that rate can be readily determined or by using the leasee’s incremental borrowing rate. The future lease payments are the fixed lease payments (including in-substance fixed payments) over the lease term. The lease term has to be determined considering extension and termination options if the leasee is reasonably certain to exercise that option.
Obviously the assessment of the lease term has a huge impact on the value of the lease liability and hence on the right of use asset. In addition, most of the property leases will appear on the leasee’s balance sheet under the new leasing approach, as it is unlikely that the leasee will exercise its termination option for property leases every 3 to 6 months. However, determining the exact lease term is, of course, highly judgemental and could be used to influence the financial results and key performance indicators in a certain direction.
What KPIs are affected?
The new lease accounting requirements will affect many key performance indicators that are important to the stakeholder communication:
Although the current “all or nothing” approach was substituted with a more “gradual” way of financial reporting and hence a better reflection of the economic reality, it is undeniable that companies have significant room for using their judgements in driving the value of the “right of use” asset and the corresponding lease liability in a certain direction.
How Swiss banks are affected
Firstly, banks are affected with their own financial statements. As most of the property leases will appear on the leasee’s balance sheet, it is expected that the new lease accounting requirements might affect banks with large retail banking business in particular. However, the impact on key performance indicators, particularly on the important equity ratios might be limited due to the large total asset bases of typical banks.
Secondly, banks are important stakeholders and users of financial statements as investment and credit decisions are based on historical financial information. As such, the respective analyst must understand the impacts of the new lease accounting requirements with their important judgement areas and areas where the company’s management can tweak the amounts that are recognised on the balance sheet.
Thirdly, banks often act as lessors in financing property, plant and equipment for their clients. As leasees are heavily impacted by the new lease accounting requirements, the banks as contracting partners should understand the impacts on the client’s financial reporting in order to better understand the motivation for certain aspects during the negotiation of the contracts and to be able to advise clients appropriately. Additionally, the clients may ask for the disclosure of interest rate the bank uses (implicit in the lease) in order to determine the lease liability and the right-of-use asset. This will lead to an increased transparency into earning and margins and should be considered carefully.