Lease changes: a moving target for franchise sector

Although the relationship between the franchisor and franchisee makes the lease arrangements more complex, it nevertheless underpins the business model and enables the business to upscale, downsize or modify service delivery as required.

But a proposed change to Australian Accounting Standards could dramatically change the way leased property, plant and equipment is represented on balance sheets, potentially costing businesses millions in compliance and education, particularly  those that lease a significant amount of assets.

While it’s still not entirely clear what the final impacts of the changes will be, as definitions and concepts are changing every day, it’s important for the franchise sector to be aware of the changes and begin thinking about how they will impact on their business.

Bringing leases on balance sheet

The main area of change for the Australian Accounting Standards, which could be finalised as early as 2015, is they would require businesses to record on their balance sheet any leased property or equipment, such as a franchisee’s operating premises.

The International Accounting Standards Board (IASB) has been discussing the issue for over five years, with the goal of providing increased transparency about a company’s assets and debts.

Currently, leases are generally classified in one of two ways; operating leases and finance leases. The classification of these leases will be determined by who bears the risks and rewards as outlined in the agreement.

In the franchise sector it is not uncommon for a franchisor to enter into a lease with a landlord for the rental of a premises. The franchisor may then enter into a sub-lease with the franchisee or provide the franchisee with the use of the premises  under a license agreement. Alternatively the franchisee may lease the premises directly from the landlord. These arrangements would likely be considered operating leases as the risks and rewards associated with the premises would generally remain  with the landlord however their treatment would need to be reconsidered under the proposals.

The other matter for consideration is whether other licenses granted by franchisors to franchisees are captured as leases under the new proposals.

Currently, operating leases are not recognised on balance sheet. This means that there is no leased asset or lease liability shown on the balance sheet, but a lease expense is recognised in the income statement periodically.

Finance leases on the other hand are recognised on balance sheet, so the leased asset is recognised as well as a corresponding lease liability.

If the changes are introduced, businesses big and small would be forced to show all leased items on balance sheet (with some limited exceptions), potentially meaning millions of dollars worth of liabilities would come onto the balance sheet. The  biggest impact of this change being that it could significantly increase the liabilities of the business without a corresponding increase in tangible assets.

This, together with any deferred tax balance consequences, could make the business look more debt laden than the books currently show, with the risk that the changed debt ratios could breach franchise agreement or borrowing agreement covenants depending on how the franchisor, franchise agreement or financier view the corresponding intangible right of use asset. These franchise or borrowing agreements may need to be renegotiated, requiring significant time, cost, effort and the potential risk that the franchise or funding relationship could breakdown.

For many businesses, the largest potential burden of the change may be putting in place monitoring and record keeping controls, as well as the costs to educate staff and financial statement users.

Begin preparing now

Unfortunately, until the final requirements are released on this change, how the ‘new’ lease accounting assets and liabilities will be viewed is unknown.

It’s also advisable that businesses start looking at their leases or arrangements that may be considered leases and ensuring they understand the terms. They need to start considering what the potential impact will be on the business as a whole  considering some franchisors or franchisees may potentially become large proprietary companies who may therefore be subject to more onerous reporting requirements under the Corporations Act 2001 depending on the type of entity used to  facilitate the franchise arrangement.

The new rules will likely impact the franchise sector significantly given the propensity of the sector to use operating leases due to the nature of asset requirements. The additional administrative burden together with the need to bring these assets onto the balance sheet should not be underestimated. The rules will also not allow ‘grandfathering’ of existing leases, meaning the rules will apply to leases negotiated historically.

Kimberley Carney is National Technical Senior Manager at William Buck. William Buck is the largest Australasian owned and operated accounting and business advisory firm, with more than 120 years experience servicing the mid-tier market. It  specialises in providing integrated business solutions in the areas of tax, audit and assurance, corporate advisory, business advisory, wealth advisory and business recovery.

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