CR Common Practices Leases

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1 Introduction IAS 17 was originally issued in 1997 and has been revised since then. One recent amendment was incorporated by Improvements to IFRSs issued by the IASB in April 2009 and this relates to the classification of leases of land and buildings. This is effective for periods beginning on or after 1 January 2010, with earlier adoption permitted as long as this fact is disclosed. More fundamentally, the IASB issued an Exposure Draft on leases in August 2010, the aim of which is to develop a new and unified approach to lease accounting. This would require that rights to use assets and obligations to make lease payments under lease contracts are recognised as assets and liabilities in the balance sheets of lessees. In effect, operating leases would move on-balance sheet. The draft has various scope exclusions and makes an exception for short-term leases. In addition, changes to rules on lease options and contingent rentals would impact on finance leases and judgment would be required on the accounting implications of these matters. This report considers recent corporate reporting of leases by a sample drawn from 22 large, listed European companies, supplemented by Company Reporting data and comment. All companies report under International Financial Reporting Standards (IFRS), following European Union requirements. We highlight the reporting of commitments under non-cancellable operating leases in the expectation that these may move on-balance sheet following impending changes to IFRS. We also comment on the degree to which the disclosure requirements of IAS 17 are followed. Key observations include the following. Most leases, by value in the accounts of lessees, are accounted for offbalance sheet as operating leases rather than on-balance sheet as finance leases. More specifically, operating lease commitments are 8.9% of the total closing equity in our sample, with the percentage being much higher for a significant number of companies. Additionally, some companies disclosures fall short the requirements of IAS 17. Companies under examination Our sample consists of 22 listed European company accounts which feature in the Standard & Poor s Europe 350 dataset with period ends from 30 June 2010 and have reported by early February The sample contains a spread of industry classes. Although Mediobanca and Porsche could have been included in our analysis, we have excluded them as a lessor bank is different in nature from the other businesses and Porsche currently reports as a holding company. Where totals for all companies are quoted in euro, these are derived by translating balance sheet figures in other currencies (UK sterling, US dollar, Swiss franc and Danish Krone) at exchange rates at the balance sheet date (or nearest date prior to that where this falls on a weekend), using rates from the FT Tables of exchange cross rates. Details about the companies used in our sample are provided below: Company Period End Auditors Country Industry Classification Associated British Foods 18 September 2010 KPMG UK Food products BHP Billiton 30 June 2010 KPMG UK General mining British Sky Broadcasting 30 June 2010 Deloitte UK Broadcasting & entertainment Compass 30 September 2010 Deloitte UK Restaurants & bars Daily Mail & General Trust 03 October 2010 Deloitte UK Publishing 1

2 Diageo 30 June 2010 KPMG UK Distillers & vintners Hays 30 June 2010 Deloitte UK Business training & employment agencies Imperial Tobacco 30 September 2010 PricewaterhouseCoopers UK Tobacco Infineon Technologies 30 September 2010 KPMG Germany Semiconductors Kone 31 December 2010 PricewaterhouseCoopers Finland Industrial machinery Lonmin 30 September 2010 KPMG UK Platinum & precious metals Novartis 31 December 2010 PricewaterhouseCoopers Switzerland Pharmaceuticals Novozymes 31 December 2010 PricewaterhouseCoopers Denmark Biotechnology Pernod Ricard 30 June 2010 Mazars & Deloitte France Distillers & vintners Roche 31 December 2010 KPMG Switzerland Pharmaceuticals Sage 30 September 2010 PricewaterhouseCoopers UK Software SGS 31 December 2010 Deloitte Switzerland Business support services Siemens 30 September 2010 Ernst & Young Germany Electronic equipment Smiths 31 July 2010 PricewaterhouseCoopers UK Diversified industrials Sodexo 31 August 2010 PricewaterhouseCoopers & KPMG France Restaurants & bars ThyssenKrupp 30 September 2010 KPMG Germany Iron & steel Wolseley 31 July 2010 PricewaterhouseCoopers UK Industrial suppliers Analysis Disclosure of operating leases: charges Of the 22 companies considered, all disclose operating lease commitments. However, two companies (Daily Mail and General Trust and Pernod Ricard) do not follow IAS 17 (para 35(c)) as they do not disclose the operating lease charge for the year. As far as the remaining 20 companies are concerned, the average charge (at the closing exchange rate) is 22.5% of commitments. Disclosure of finance leases Of our sample of 22 companies, 17 disclose liabilities in respect of finance leases, which are accounted for on-balance sheet. Only 12 companies disclose the carrying amounts of assets held under finance leases, though this is also required by IAS 17 (para 31(a)). The five companies with finance leases that do not disclose the amount of leased assets are: BHP Billiton, Daily Mail and General Trust, Diageo, Pernod Ricard and Siemens. Operating versus finance leases: relevant amounts In view of the impending move of operating leases onto the balance sheet, we compared the amounts of finance and operating leases disclosed by our sample companies. We identified 18.2 billion commitments under non-cancellable operating leases that were disclosed in the notes. These overshadowed the 1 billion finance lease liabilities identified on company balance sheets. Only six companies had finance lease liabilities greater than 10% of their noncancellable operating lease obligations. For eight companies, finance leases were under 1% of operating leases. The 18.2 billion obligations under non-cancellable operating leases remain off-balance sheet, with disclosure of their amount required by IAS 17 (para 35(a)). 2

3 The 18.2 billion obligations disclosed represent 8.9% of the total equity in our sample. However, there is a wide variation amongst the sample with the average reduced by two companies, Novartis and BHP Billiton, whose equity is 58% of the total, making relatively little use of operating leases at 4.5% and 6.2% respectively. Of the others, six companies disclose obligations more than 25% of their equity and 15 over 10%. The amounts brought into the balance sheet under the proposed revision to IFRS requirements on leasing could be greater than 18.2 billion, as the proposals are not limited to non-cancellable obligations. The table below summarises the figures disclosed by our sample companies, with regard to finance and operating leases. Company Currency Finance Assets Finance Receivables ***Finance *Finance Charges Operating Charges **Operating Commitments Financial Assets Financial Operating Associated British Foods , ,274 BHP Billiton US$ , ,496 British Sky Broadcasting Compass Daily Mail & General Trust Diageo Hays Imperial Tobacco Infineon Technologies Kone**** Lonmin US$ Novartis US$ , ,356 Novozymes DKK Pernod Ricard Roche CHF Sage SGS CHF Siemens 4, , , ,126 Smiths Sodexo ThyssenKrupp , ,066 Wolseley , ,553 Figures for group as lessee, except 'receivables'; excl. Equity accounted disclosures; FOREX to Euro conversion rate at period end date taken from FT. *includes Hire Purchase payments; excludes depreciation of finance lease assets & lessor lease income. ** net of sublease receivables if disclosed. *** excludes onerous lease provisions. **** Fin lease liabilities exclude 0.9M interest. 3

4 The table below summarises the amounts disclosed by our sample companies, with regard to finance and operating leases. Company Financial Operating Shareholders Equity Operating As a % of Shareholders Equity Financial as a % of Operating Associated British Foods 53 2,274 6, % 2.3% BHP Billiton 184 2,496 40, % 7.4% British Sky Broadcasting % 33.8% Compass , % 8.2% Daily Mail & General Trust % 10.3% Diageo , % 9.1% Hays % 0.0% Imperial Tobacco , % 22.3% Infineon Technologies , % 0.0% Kone**** , % 11.8% Lonmin - 1 2, % 0.0% Novartis 3 2,356 51, % 0.1% Novozymes , % 0.0% Pernod Ricard , % 26.5% Roche , % 0.1% Sage , % 1.7% SGS , % 0.8% Siemens 171 3,126 29, % 5.5% Smiths , % 0.0% Sodexo , % 14.5% ThyssenKrupp 87 1,066 10, % 8.2% Wolseley 90 1,553 3, % 5.8% Summary - Conclusion Our principal conclusions are that: Disclosure of finance lease assets in the accounts of lessees falls short of current IAS 17 in several instances. In our sample of 22 large European companies, most leases by value in the accounts of lessees are accounted for off-balance sheet as operating leases rather than on-balance sheet as finance leases. Operating lease commitments are 8.9% of the total closing equity in our sample, with the percentage being much higher for a significant number of companies. Thus, should leases currently classified as operating leases move on-balance sheet following expected replacement of IAS 17, there will be significant balance sheet effects by increasing companies gearing. 4

5 Illustrative Extracts BHP Billiton: Accounting policies for leases BHP Billiton discloses an accounting policy on leases in line with current IAS 17. The policy covers finance and operating leases, lease incentives and the treatment of onerous leases: Diageo and Daily Mail and General Trust: General description of material operating lease arrangements Diageo in 2010 discloses a general description of material leasing arrangements that discusses contingent rent, renewal or purchase options or restrictions. Meanwhile Daily Mail and General Trust does not address these issues: 5

6 Diageo 2010 Daily Mail and General Trust 2010 BHP Billiton: Disclosure of lease liabilities BHP Billiton includes liabilities under finance leases and operating lease commitments in its note on commitments. Following IAS 17 (para 31(b)), the $225 million discounted carrying amount of finance leases is reconciled to the $444 million total commitment. Typically for our sample, the great majority of leases are classified as operating leases: 6

7 SGS and Siemens: Disclosures involving concepts of capital management and net debt Swiss company SGS includes liabilities under finance leases in its concept of capital, but not commitments under noncancellable operating leases. It remains to be seen what impact impending changes in lease accounting will have on this policy and disclosure: 7

8 Meanwhile, Siemens discloses a concept of net debt that will also require adjustment for changes to IFRS treatment of leases in 2010: Siemens: Redesignations of cash flows and capital expenditure Siemens comments that Improvements to IFRSs (May 2008) affecting IAS 7 Statement of cash flows has led it to reclassify cash flows arising from operating leases and alter its concept of capital expenditure: 8

9 Diageo: Disclosure of sale and leaseback transactions Diageo in 2010 discloses a sale and leaseback transaction giving rise to an operating lease, the accounting for which led to 134 million receipt in the year and recognition of an 89 million gain, triggering disclosure requirements under IAS 1 Presentation of financial statements : 9