Connector Strategic Partner and expert in Good Governance and Risk Management, Roel Hindriks, answers 5 key questions about IFRS
20 years ago
In 1997, Roel heard for the very first time about an initiative by the Board of International Accounting Standard (IAS) to tackle the off-balance effects of operating lease. The IAS Board had started up discussions around the topic with its American counterpart, US-GAAP, with the long term objective to report liabilities from operating leases in a harmonised way.
Initially, the depreciation of the leased object during the lease period was taken into account as the starting point for the reporting in financial statements. However, for contracts in which the depreciation was relatively small or non-existing (e.g. buildings), this was considered to be insufficient.
This is why the total amount of periodic lease payments was put forward as a better basis for the accounting purposes. To determine the value of future payments, the following elements need to be taken into account: the present value, the applicable interest rate and the periodicity of the payments. In contrast to the payment obligation, the lessee acquires the right to use the lease object and that should also be included in the financial balance sheet as an asset.
Let's take a hypothetical vehicle, leased for 48 months at $1,000 per month (without fuel). According to the principle described above, the IFRS value totals at $48K, which would be an excessive. So... are things different for car leasing? Here are Roel's answers to the 5 essential questions about IFRS.
1. What part of the lease fee enters into IFRS calculation?
Most European full-service leasing agreements include maintenance, repair, road taxes and insurance premiums. Only a minority of lease contracts (so-called unbundled lease contracts), only cover the depreciation, interest and administration costs. In other regions, this is much more frequent.
Therefore, service cost elements need to be deducted from the total lease fee, otherwise there will be illogical differences between the treatment of car lease and other types of leasing.
Operating leases of vans, trucks and special vehicles exclude often services, such as maintenance and repair (net operational lease)
Similarly, in the the case of real estate leases, the costs of taxes, insurance, security and maintenance, are also excluded from the lease fee. Only the nett rent fee counts as the basis for the IFRS processing.
For this reason, there's an understanding among lease- and fleet-management experts that only the compensation to the lessor for "making the vehicle available", i.e. depreciation, interest and management costs, should be taken into account.
2. Up front payments
Although uncommon in mature markets, lessor and lessee can agree that the lease starts with a prepayment of a substantial upfront payment, either for credit approval reasons or to facilitate possible earlier terminations of the contract.
The first payment impacts the primary depreciation of the lease-object and reduces the periodic lease fee for the entire lease period. Consequently, it also reduces the costs of a premature contract termination.
Reducing the total value of the lease installments might reduce the present value of the liabilities but leaves the value of the user rights obtained from the lease unaltered. In other words, if the upfront payment needs to be taken into account for the IFRS calculation.
3. Processing purchase bonuses or free services
Fleet clients receive discounts and additional services; the more orders, the higher the value of such marketing efforts. These additional conditions can be included in the lease price, but it is also possible that the bonuses are made available directly to the lessee and are considered as a "provision" in respect of the lease obligations. Therefore, it's most likely that the bonuses need to be included in the value for IFRS calculation.
4. Discounted (Present) value
The ratio between capital and interests in monthly lease fees is most likely to change in the course of the contract, the mass of interests being pushed to either end of the contract. In other words, closer to the end of the leasing contract, the amount of interests paid can be lower than in the beginning of the contract.
The question is therefore, should the lessee report a different interest amount each month?
In the explanatory notes to the IFRS, it is stated that the interest rate can be adjusted annually to match the interest rate that is appropriate for the lessee's financing on the financial market.
Consideration could also be given to applying a completely different interest rate, such as the percentage equal to return on investment or equity.
5. Movements in balance values
A further aspect in which the leasing expert is only an observer, concerns the decision how to proceed with the values, linear or annuity. This choice affects the valuation of what has been paid to the lessor; In the event of an annuity, at the beginning of a lease contract the "obligations to the lessor" and also the "value of the right of use" will decrease less and a corresponding higher amount of interest costs will be booked.
Here it's up to the lessees and their CFOs to determine the best methodology
Heavy administrative burden
Ask any international fleet manager. They will have vehicles in different countries, with different suppliers. Accounting standards however should be harmonized across the categories and countries.
Exactly this point will is difficult - it might become a commercial argument for the global players to offer harmonized reporting; in any case, it'll be up to the fleet managers to pass the message of their suppliers to their CFOs and assist them in making the right strategic choices. Or... would you accelerate the implementation of mobility solutions?