Path of Lease Resistance

By Marc Casal on September 7 2010

As covered recently in our ‘To Lease or Not to Lease?’ post, the financial modelling of leases hinges on the central issue of classification between operating leases and capital (finance) leases. However, a new joint proposal by the International and American accounting standards boards seeks to throw this distinction out the window.

Reforming lease accounting

On 17 August 2010 the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) of the United States published for public comment a proposal to change the way that leases are accounted for. Under the proposal, a ‘right-of-use’ approach will be adopted for lease accounting.

In simple terms, this means that most leases will be recognised as assets and liabilities on the balance sheet. This is similar to the present treatment of capital leases.

Causing controversy

According to the IASB, much of the estimated $640 billion of lease commitments which occur annually do not appear on the balance sheet of lessees. The proposed changes, if enacted, will therefore have widespread ramifications on corporate gearing levels and profitability. By pushing leases on to the balance sheet, corporate debt levels will increase materially in most cases. Conversely, corporate profitability will typically improve as lease payments are no longer expensed.

The Rotterdam School of Management, Erasmus University and PwC Netherlands conducted research to measure the effect of the proposed changes. An analysis of the reforms on 109 companies in America, Asia and Europe produced the following headline statistics

Average increase in interest-bearing debt: 8%
Average increase in EBITDA: 7%

According to the research, the impact of the changes is even more pronounced within the retail and trade and professional services sectors.

Reactive reform

Traditionally, accounting regulators draft reforms in the wake of calamity. This was the case a decade ago, when the collapses of Enron and Worldcom sparked a revamp of mark-to-market accounting, special purpose vehicles and related party disclosure standards.

The events of the global financial crisis have clearly weighed heavy on the minds of regulators. The lease reforms are an attempt to improve the transparency of financial reports following the troubles suffered by a spate of debt-laden financial institutions during the contagion.

Impact on financial modelling

The news is good for financial modellers. No longer do we need to consider the sometimes tricky business of classifying leases, as almost all leases would be capitalised. Furthermore, in analysing project data the uniform treatment of leases will make it easier to compare projects.

On the flipside, the changes may make life just that little bit harder for companies trying to seek additional funding from financial institutions, as gearing and interest coverage ratios will deteriorate if the reforms are enacted.

All eyes will be on the standards boards as they undertake a consultation process to determine whether the new rules should be adopted.