Accounting standards change affects leased equipment

Major changes in financial reporting have started in recent years, with the most obvious being the continuing adoption of International Financial Reporting Standards (IFRS) worldwide.

Many countries have been using IFRS for some years, and more are planning to adopt the standards, which were first introduced to the Canadian accounting profession in 2011 by the Canadian Accounting Standards Board.

Before 2011 most followed the generally accepted accounting principles (GAAP) specifications, which is a collection of commonly followed accounting rules and standards for financial reporting.

The financial crises of the past several decades, including the savings and loans crisis, Enron, and the sub-prime meltdown, created a demand for mark-to-market (MTM) accounting, a measure of the fair value of accounts such as assets and liabilities, which normally change over time. The goal of MTM is to provide a realistic appraisal of a company's current financial situation.

One of the consistent features of these crises was that assets were improperly valued or were not consistent with the reality of the marketplace.

In addition, as the economies of the trading countries have become more integrated, there was a clear need for consistent financial reporting that allows various international market participants to understand each other’s financial reporting. This has led to a push toward MTM accounting.

Introduction of IFRS

IFRS is the standard for Europe and is essentially a consequence of the European Union integration. Canada was the first North American country to introduce IFRS, but the U.S. has pushed back the introduction of these types of accounting changes several times. The accounting standards boards are still trying to reconcile the GAAP standards with IFRS and have introduced several standard changes as they work toward the accounting practices standardization.

The underlying principle of the IFRS is a concept of fair value. This is not necessarily the same as the financial industry’s widely accepted definition of fair market value, which an equipment appraiser would describe as the estimated, probable price expressed in terms of cash to be realized for property in an exchange between a willing buyer and a willing seller, with neither being under any compulsion to buy or sell, and both parties fully aware of all relevant facts.

Understanding fair value from an IFRS perspective is much more complex, because the definition is intended to apply to all classes of assets, from shares on the stock market to real estate.

The introduction of IFRS in Canada has been very inconsistent. Publicly traded companies were the first to comply. The most common time to transition is when there is a purchase or some sort of share transaction. Privately held companies are only now slowly starting to change over, and the Accounting Standards Board has even introduced a simplified set of standards to encourage these conversions, which is called the Accounting Standards for Private Enterprises (ASPE).

ASPE are accounting principles for small and medium-sized enterprises (SMEs) in Canada that publish financial statements for general-purpose use but do not have to report their financial results publicly because their shares are not traded on a public stock exchange.

Two of the main goals of ASPE was to make the preparation of a company’s financial statements less complicated and to boost the confidence of the people who use it for decision-making.

How IFRS affects leases

One of the major changes brought about by this transition is the accounting treatment of leasing.

Under GAAP, leasing is considered as off-balance sheet financing, which is commonly referred to as an operating lease. This is a contract that allows for the use of an asset but does not convey rights of ownership of the asset. The leasing company, in fact, maintains ownership throughout the transaction.

The equipment is not listed as an asset in the financial statement, but instead accounted for as a rental expense.

IFRS, however, requires that leases appear on the balance sheet. The manner in which this is done depends on the nature of the lease. This issue is also the subject of the changes taking place in the U.S. with the intention of harmonizing the accounting between the two standards.

One of the consequences of MTM accounting is that if it’s applied rigorously, the balance sheet can vary dramatically from year to year, leading to some undesired tax implications. As a result, many accounting firms are not actually valuing the assets every year; instead they review the values only when there is a major event, a sale, or an ownership change, when the accurate value of the company is required for reasons beyond the filing of a yearly tax return or prestation to a lender.

For the normal interim reporting, many companies are simply doing a GAAP-style depreciation, which, of course, somewhat defeats the motivating principle of MTM.

There is no doubt that change has come to the accounting reporting standards, particularly for both asset value and leasing. That said, the best advice I can provide to manufacturers is to discuss and review how these changes could affect their business with their accountant or financial adviser, because they are experts in this area.