JV Leasing (Pty) Ltd P.O. Box Bryanston South Africa September 2013

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1 P.O. Box Bryanston South Africa September 2013 Hans Hoogervorst, Chairman International Accounting Standards Board 30 Cannon Street London EC 4M 6XH United Kingdom Leslie Seidman, Chairman Financial Accounting Standards Board 401 Merritt 7 P.O. Box 5116 Norwalk, CT Proposed ASU, Leases (File Reference No ) Dear Mr. Hoogervorst and Ms. Seidman: JV Leasing is a company that specialises in providing companies with outsourced leasing services for meeting their customers operating lease requirements. The Proposed Accounting Standards Update (Revised) issued May 16, 2013 (PASU) for IAS 17 presents the accounting profession with an opportunity to better account for leases and any resulting lease commitments and liabilities. A primary indicator of any business s financial performance is its underlying cash flows, their associated risks and the timing thereof. When financial reporting moves away from reporting a business s underlying cash flows it opens the door to complexity which can confuse users of financial statements. As accountants we tend to inherently complicate matters. We interpret matters on a substance over form basis, often incorporating technical economic and legal theory, which requires accounting expertise and experience to understand. Where ownership is passed to the lessee in the lease agreement then the current IAS 17 treatment of capitalisation of the asset and liability, and the recognition of interest on an amortisation basis is believed by JV Leasing to be the correct accounting treatment. The underlying nature of the lease contract which incorporates a change of ownership of the equipment, or deemed change of ownership as per IAS 17 s risks and rewards of beneficial ownership, is similar to that of a financed sale. Therefore any difference between the cost of the asset and the sum of the lease payments represents finance charges which should be amortised over the lease period.

2 Financial leases would appear to take a precedence of focus in the current IAS 17 and in the PASU. It is respectfully submitted that operating leases are an important commercial structure and should receive more focus from, and understanding by, the relevant accounting bodies. Caution is urged not to paint finance and operating leases with the same brush. OPERATING LEASE TRANSACTIONS Operating leases are contracts whereby users are able to enjoy the use of asset and reduce the risks and costs normally associated with ownership of the asset. The avoidance of risk is very important to well-run companies and enables them to provide more efficient and consistent services to their customers and generate consistent and superior returns for their shareholders. Operating leases also simplify the understanding of financial reporting for users of financial statements. Operating lessees are able to: Simplify their accounting and thereby lower their accounting costs, Obtain certainty with regards to cash flows, Avoid higher maintenance costs at the end of the assets life, Avoid assets technical obsolescence, Avoid asset disposal costs at the end of use, Pay only for the portion of the asset that is utilised, and Obtain outsourced benefits i.e. obtain a full service solution utilising the asset which the lessee utilises in providing a more comprehensive solution to their customers. Operating lessees avoid taking risk on changes in the underlying asset s residual value (asset risk). The value of the benefits operating leases bring to lessees is evident by the volume of operating leases that are concluded every year in the commercial world. Operating leases offer tangible benefits over and above the use of the asset and these tangible benefits cannot be ignored.

3 Capitalisation of the present value of operating lease payments as a liability by the lessee Commitments versus liabilities As per the Conceptual Framework: A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. An operating lease agreement is comprised of a number of lease payments as defined by a lease schedule and these are normally spread evenly over the lease term. As per the Conceptual Framework a liability can only arise if there is a present obligation arising from past events. In order for an obligation to arise the lessor has to first make the contractual delivery of providing the leased asset to the lessee for use during the relevant lease payment period. If the lessor does not deliver the asset, and the lessee does not have the use of the asset for the relevant period, then no obligation arises on the lessee. Without an obligation there can be no liability. If the lessor were to remove the leased asset during the contracted lease period from the lessee, in breach of the operating lease contract, or the lessor were to become insolvent and the asset is repossessed by liquidators the lease contract would be unenforceable by the lessor as no delivery of the asset would have taken place. The signing of an operating lease contract therefore does not create a contractual liability but rather it creates a contractual commitment between the lessor and the lessee. Operating lessees should only raise the liability of a lease payment when each rental payment becomes due and payable as per the lease schedule as it is only at this point of the contractual relationship where it can be ascertained with certainty that the lessor has made the asset available for the use by the lessee. The availability of use of the asset creates the obligation from a past event which in turn creates the liability. A finance lessee should raise the present value of the lease payments as the total liability for the lease contract on the later of the delivery of the asset or the signing of the lease agreement. It is only at this point that the obligation arises on the lessee and substantially all the risks and rewards incidental to ownership of an asset transfer. The capitalisation of other benefits as lease liabilities As detailed above, operating leases provide additional benefits to lessees which finance leases do not. These operating lease benefits will differ per lessee and each lessee may place a different value on each benefit. Whilst lessors may be unable to precisely quantify the value of the benefits the operating lease product possesses a distinct additional value when compared to finance leases.

4 Given the value lessees attach the operating lease benefits is unquantifiable any attempt at calculation of an implicit leased rate is impossible for operating lessees. If the lessee were to utilise the implicit interest rate that finance leases utilise this would result in these operating lease benefits being treated as finance income. This is inherently a misrepresentation of the commercial benefits of operating leases. The capitalisation of the right of use asset by the lessee 1) The requirement of capitalising the right of use asset undoes the cost benefits and simplicity of accounting that lessees obtain from operating leases. In many instances complex and costly system changes will be required in order for businesses to cope with the volume and complexity of the calculations required. The accounting profession is adding additional costs to lessees in order that the financial statement s user will obtain benefit which could in all likelihood have been provided more efficiently and comprehensively in the financial notes disclosure. 2) It would appear from the PASU that the nature of the right of use asset is a compromise arising from double sided journal entry process which seeks to raise the commitment of a lease to be disclosed and a corresponding debit being necessitated on the statement of financial position. The vague and subjective treatment afforded to the lessee regarding the depreciation of the right of use asset is reflective thereof. 3) In seeking a debit balance for the lease commitment for operating leases the unintended effects of the PASU are that: a. The present value of future costs for the use of the leased asset will be capitalised, b. Which relate to future contractual commitments, c. The obligation for which only arises on the appropriate lease schedule payment dates, d. Providing the lessor has met his contractual commitments and any related terms of providing the asset for the use of the lessee. This treatment is technically incorrect. 4) It is felt that the PASU creates confusion between a company s future contracted commitments and liabilities in trying to raise a right of use asset on operational leases. Companies have multiple contracts all of which commit them to future expenditure. It would be extremely onerous for assets with corresponding liabilities to be raised for all these contracts.

5 An example of auditor fees comes to mind. Auditors are appointed at the beginning of the year and the fee is agreed. The audit is a statutory requirement and there is no uncertainty that it will take place. Should the commitment now be raised with a corresponding liability at the beginning of the financial year? Another example for commitments that exceed a year in duration would be contractual commitments arising from contracts such as with directors or contract staff or contracts encompassing the provision of services. It is submitted that if commitments are to be considered for capitalisation on the statement of financial position then a consistent approach to all commitments should be utilised and leases should not be approached differently. 5) The capitalisation of a right of use asset implies that there is an asset on the statement of financial position which other creditors would have a right to attach in the event of liquidation. Clearly no asset exists on liquidation as the lessor will repossess their asset in the event of the lessee defaulting on payment. This matter is easily clarified in the note disclosure; however it does add further detail and complexity for the user of the financial accounts. 6) As accountants we need to ask ourselves what the net value between the right of use asset and capitalised liability represents. If there is a net asset is the business owed anything different from if there is a net liability due to different amortisation methods being adopted? The organisation still has the full asset at its disposal for its use and the underlying cash flows remain the same. What commercial reality are we trying to show the user? 7) The depreciation amounts of the right of use asset could vary significantly from the cash flow costs actually incurred in the operating lease. Users of financial statements will in all likelihood reverse any depreciation and interest amortisation to determine the true cash flow of the reporting entity. This being the case why would we elect to impose costs on businesses in the name of user requirements when the very same user would reverse these changes? 8) Users will be required to capitalise a right of use asset and will in all probability have little knowledge of the asset and any depreciation they provide will not therefore be representative of the true cost of the assets utilisation. Depreciation amounts could easily vary across entities using the same asset over the same period. This will be highly confusing for any user. 9) The proposal that leases less than twelve months be exempt for the scrutiny of whether the lease is an operating of financial lease and capitalisation does not make sense from a consistency of accounting treatment perspective. There appears to be no obvious logic in selecting twelve

6 months as a cut off. If a contract falls over the financial year of a company would users still presumably want to see a finance lease capitalised in the accounts? Accounting requires consistency of treatment for users to have any faith in the preparation of financial statements. The capitalisation of an operating leases right of use asset does not provide this conceptual consistency, does not follow the commercial reality of the cash flows nor correctly reflect the financial position of an enterprise. Operating lease interest revenue and expense recognition The PASU is proposing that the revenue from the capitalised portion of the operating lease be reported as amortised interest income or interest expenditure depending on whether the reporting entity is the lessor or the lessee. The proposal goes against the underlying nature of operating lease income, and materially complicates how operating lessors and lessees currently report their income and expenditure in relation to the transactional cash flows. Operating lessors make their revenue: 1) by taking asset risk which is the risk that the asset will become obsolete before the lessor has recovered their investment by leasing out the asset, and 2) Providing the additional risk mitigation benefits of not owning the asset as previously highlighted. An operating lessor calculates the lease charges to make a profit on that portion of the asset utilised versus the lessor s estimate of the future residual value of the asset. The residual value the operating lessor utilises in their profit calculations may vary significantly from the lessee s residual value as lessors are often specialist in their asset type and are able to generate additional residual value through careful maintenance and specialised disposal channels. As the lessor is taking residual value risk they charge a fee for the estimated depreciated use the customer will incur. The calculation can be on hours used, units produced or even average expected use over a period of time. It would be hard for lessors and users of financial statements to understand a fee that is related to the use of an asset being classified as interest income and recognised on an amortisation basis. There is de facto no monetary loan in effect in an operating lease structure. A physical asset has been loaned to the lessee and the same physical asset will be received at the end of the lease term. It is therefore incorrect to assert that the lessor s revenue for the operating lease asset is interest income. Operating lessors are being required to move from the commercial and sensible reality of lease income being defined by tangible cash flows to recognising revenues as interest.

7 Operating lessors are not bankers. They provide a valuable risk and cost mitigation product through their expertise in the leased asset and in their willingness to take asset risk on the residual value of a leased asset. To imply operating lessors earn interest income or that lessees are purely entering into an operating lease to finance assets displays a lack of understanding of the product and value that operating leases bring to industry. The current thinking entrenches a banking mind-set which is just plain wrong. If the lessee had elected to forgo the benefits of an operating lease and acquired ownership of the asset then the transaction would become a financing transaction where the recognition of interest revenue / expenditure recognition would be appropriate. Capitalisation of an operating leased asset The entity that is in the business of making profits from the supply of the leased asset and the services detailed above and, that has a material stake in the residual value of the leased asset should capitalise the asset onto its statement of financial position. Summary of matters affecting operating lessors 1) Operating lessors are not in the business of generating interest revenues. They are in the business of providing risk and cost mitigating asset usage structures to their customers through which they generating tangible cash flows. 2) Operating lessors are frequently a specialist in their asset type and are able to enhance the residual value of the asset through maintenance and established disposal channels which are not available to the lessee. The higher residual value creation forms part of the profitability or operating lessor s margin on the lease transaction and is normally not disclosed to the lessee. 3) The cost of implementing the Boards proposal will force more administrative and compliance costs on all businesses. Marginal businesses may be financially put at risk. 4) The skills base in developing countries will be hard pressed to support the vast number of complex amortisations and systems changes that will be required. Matters affecting lessees 1) Businesses want to stick to their knitting and reflect assets and liabilities that reflect their business operations and their commercial reality. 2) The cost of implementing the Boards proposal will force more administrative and compliance costs on small or marginal businesses.

8 Illustrations 1) Small operating lessors Accounting needs to be relevant to an enterprise. Small lessors could be compromised by the additional complexity of moving towards recognising revenue on an interest turn basis. An operating lessor s cash receipts are his revenue and the depreciation are his costs. These are easy to understand concepts to understand and tie into the commercial reality of the underlying cash flows. The business owner is able to keep his own records and manage his business. The greater the cash flows of the business then the greater the profit of the business and vice versa. Now the accounting profession is proposing the operating lessor is actually earning interest and needs to recognise the interest on an amortisation basis. As a result of the complexity created in his business and the time consuming amortisations that need to be performed the operating lessor may need to incur additional costs of hiring a person to perform accounting which he was previously able to do himself. The additional costs reduce the operating lessor s profitability. Operating lessors unable to afford the additional costs or unable to cope with the complexity may be put at risk. 2) Small operating lessees A small IT company wants to build a rugby field for its staff and contracts with a building contractor to build the field which will take thirteen months. The building contractor requires yellow metal equipment to build the field which is written up on a leasing schedule to the IT company and which is then discounted with the local bank to help fund the development (assuming a good residual value on the equipment after the rugby field development). The IT company will now be required to capitalise the right of use of the yellow metal asset on its statement of financial position which has nothing to do with its operations. Furthermore, the bookkeeper will have no experience with yellow metal goods or the depreciation thereof. The cost and complexity of amortising every rental asset will create an additional administration burden for the company and confuse users of the financial statements who would want to know why an IT company was investing in yellow metal assets.

9 3) Large lessees Airlines frequently do not have the aircraft which they use capitalised onto their statement of financial positions. It is submitted that the commercial reality is that airlines are not in the business of making profit by taking risk on aircraft they are a logistics business specialising in the business of transporting people. To reduce shareholder risk in exposure to changes in aircraft values, technological obsolescence (etc.) the aircraft are leased. This brings greater stability and cost certainty to the airline. In the commercial world the leasing of the aircraft is a commodity booked as a cost of sale or expense and not as an asset to the airline company. Capitalisation of the right of use asset in the company s accounts changes the nature of what a business is reporting about itself which could incorrectly affect the user s understanding of the risks that a business is actually exposed to. Possible impact on business There could be serious financial implications on businesses and livelihoods which the PASU may unintentionally inflict on the commercial business space. Many small firms rely on the sale of operating lease asset to small businesses over a lease period of three years. The three year contract period is used to present an affordable cost to the lessee and a discountable transaction size that is sufficient to cover the cost of the asset. (The lease payment normally would incorporate a service charge to ensure the system was serviced and operational.) Many of these leases are evergreen they continue until the equipment is removed. The lessees additional cost burden of capitalising the right of use asset could result in fundamental changes to the buying patterns of lessees acquiring these assets with devastating results on employment. This would be particularly applicable to the office automation and telecommunication industries. I am sure the Boards have also fully considered the implications of companies having to capitalise additional liabilities to their statement of financial positions which could result in existing credit facilities on which they rely being withdrawn, or further facilities being declined, or the facilities interest rate pricing being upwardly revised. In these times of austerity and financial crises this may be all that is required for a company that is currently employing people and managing to keep afloat to being placed in financial difficulty.

10 Conclusion The proposal is insufficient as it currently stands to meet the users, lessors and lessees requirements in financial statements. It is respectfully submitted that the efforts to bring operating lease liabilities onto a lessee s statement of financial position ignores the fundamental underlying differences between finance and operating leases in the name of expediency. The proposal ignores the commercial reality that operating leases are an entirely different product from financial leases and therefore any type of standardisation of accounting treatment is entirely inappropriate. The future impact of these changes on lessors, lessees and the users of financial statements will be significant. It is our opinion that capitalisation of an operating lease liability is legally flawed and makes the incorrect assumption that all revenue is interest rate driven. The capitalisation of a right to use asset is misleading and technically incorrect. The capitalisation of the right of use asset seeks to impose on businesses a complex theoretical calculation of profitability which inflicts cash flow timing differences on the reporting of profits. The proposal can only increase business costs and due to the number of lease arrangements an entity has the cost impact is material for reporting entities and the broader industry as a whole. It would seem that a complex solution is being proposed when a disclosure of a company s contracted future commitments which are reconciled to the financial statement s liabilities might suffice This document, which started off as a couple of points, has ended up as this thesis. It was written due to the importance of the subject and the experience we have in the leasing sector which I thought we could share with you. We do not have the resources for complex technical analysis and cross referencing of the exposure draft to the other statements or even for another technical review of this document. Due to the scope of the exercise and our limitation on resources and time I therefore beg your indulgence to in errors contained herein. Yours sincerely, Guy Rice guy.rice@jvleasing.co.za