Freddy Kouame is HardSoft’s new Finance Manager, he has a Bachelor’s degree in Financial Economics, as well as a Master’s in Banking and Finance, and is an avid Liverpool FC fan.
We asked Freddy to talk about Financial Leasing and Operational Leasing, and explain how IFRS 16 (International Financial Reporting Standard 16) came into effect.
We can classify leases in two different way:
Finance leases: when all the risk and reward transfers to the lessee. The lessor is the legal owner of the asset during the lease period while the lessee records a liability and an asset related to leasing in its Balance Sheet.
Operating leases: when significant risk and reward remains with the lessor.
As you see, the person holding the risk and reward will determine the type of lease it is. A lot of leasing companies of machinery, aircraft and vehicles operate in the latter, including us. The leases run for less than the full economic life of the asset and the lessor allows the lessee to use the asset for the agreed period (e.g. 24 Months, 36 Months). The lessor would expect the asset to have a residual value at the end of the lease (lessor may sell this item or lease it again). Lessees recognise the rental or lease expense in the Profit and Loss account but do not acknowledge the asset (or liability) on their Balance Sheets, making these assets ‘Off-Balance Sheet’ items.
Companies used this as a loophole to present their financial health unfairly to investors, simply because they were not obliged to show their financial obligations.
The biggest cause of death by “Off-Balance Sheet” practice is Enron, which led to the introduction of IFRS 16. Once a successful energy company, poor investment choices led to debt which was hidden through the manipulation of mark to market accounting and the use of shell companies to hide liabilities.
The first issue was that leases are similar to loans (both financial obligations) but at the time were not recorded and remained off Balance Sheets. Another issue was that companies did not have to disclose the liabilities of any partnerships in which they had an interest on their Balance Sheets. Enron exploited these loopholes and hid a lot of its activities through promising partnerships with companies such as Blockbuster (this was exciting news for investors and increased their stock prices but this partnership yielded almost no return) and shell companies where they simply hid debt. Investors who were none the wiser were not receiving the full picture of Enron’s financial position.
From 1st January 2019, IFRS 16 removed the divide between Finance and Operational leasing. Any leases over 12 Months must now be presented in the company Balance Sheet and Profit and Loss accounts. The IASB estimates that over $2.2 trillion (£1.7 trillion) of assets and liabilities will transfer onto corporate balance sheets in the coming years. This was not welcomed by companies because of the increased amount of liability they would now have to show the investor and the amount of preparation that would be needed. In addition, ratios used by investors such as the Gearing ratio and Debt/Asset ratio would now show that a lot of companies were less investible. IFRS 16 has somewhat evened out the investment playing field. Which takes me to my point…
IFRS 16 is not a law to discourage Leasing. Leasing offers flexibility and certainty of cash flow benefits. Leasing offers you the chance to own premium assets at a low monthly expense. Here at Hardsoft, we also give you access to technical support with the asset which saves you money on in–house Maintenance i.e IT Teams, allowing you to focus on your actual business operation. IFRS 16 is simply a tool to improve transparency in accounting for all level of investors.
The Enron shares kept growing which attracted more investors who were, as I said earlier, none the wiser. Had a rule such as IFRS 16 been in place, investors would have seen the TRUE financial health of the company. With $2.2 trillion (£1.7 trillion) of assets and liabilities transferring into balance sheets in the coming years, I believe we are in for a more transparent and fair finance market.
If you’d like to find out more about leasing and financial regulations, you can contact Freddy on 020 7111 1643 or email firstname.lastname@example.org. For more information about products and our leasing solutions, call our sales team on 020 7111 1643 or email email@example.com. You can also use the webchat on our website.