Laying bare the cost of operating leases and the impact on executive incentive plans
24/05/2013
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With anaemic earnings growth in recent times the mantra of many companies has been to increase efficiency. Executive incentive plans have been re-aligned to focus more on the management of working capital and maximising the return on invested capital. This has filtered into many companies’ LTI metrics, with the application of various capital efficiency requirements related to returns on capital.

The announcement by the Australian Accounting Standards Board (AASB) on 21 May 2013 of prospective changes in the accounting for operating leases has implications for some companies and their executives subject to these LTI metrics. The core principle of the proposals is that an entity should recognise assets and liabilities arising from a lease. In accordance with that principle, a lessee would recognise assets and liabilities for leases with a maximum possible term of more than 12 months.

Basically, it is proposed that new standards will apply to include operating leases on plant and equipment in the balance sheet, while also separately categorising income and losses in the income statement and cash flows in the cash flow statement arising from the use of leased assets.

Most risk-averse companies already incorporate underlying earnings and return on capital measures with such modifications in their executive incentive plans. Unfortunately, however, some companies do not. In addition, we have noted that some companies have not been paying enough attention to the locked in contractual lease period and matching these up with contracted service periods from customers – potentially risking exposure when the music stops, and there is no project work to be had.

So one positive outcome may be that the revised accounting standards may force certain companies to consider the implications more broadly. This will include board remuneration committees applying revised capital return metrics to executive incentive plans.

Starting early on revising metrics in incentive plans will motivate executives to focus on management of underlying assets and earnings to ensure a more respectable disclosure when the standards come into force.

The AASB exposure draft can be found HERE.

© Guerdon Associates 2021
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