“To lease or to buy? [Conclusion]” by John T. Villa (September 22, 2010)

SUITS THE C-SUITE By John T. Villa
Business World (09/22/2010)

Conclusion

In last week’s column, we introduced the changes to lease accounting proposed under an Exposure Draft (ED) which the International Accounting Standards Board (IASB) released on Aug. 17.

This article now looks at how those changes might affect businesses.

For lessees, the most obvious effect would be the “bulking up” of the balance sheet for amounts that are, under the current lease accounting standards, off-balance sheet. What would have been recognized as expense over the lease period under the operating lease model will now be recognized upfront as an asset. As a result of the on-balance sheet treatment, some gearing ratios may deteriorate even if cash flows and business activities stay unchanged. For certain regulated entities, such as banks, the additional asset booking might attract capital charge, depending on how the regulators will respond to the proposed changes. Moreover, the lease expense would be replaced by an interest expense on the financial liability and the depreciation expense on the right-of-use asset.

As a result, while debt coverage ratios will suffer, EBIT or EBITDA will likely improve. The reassessment of lease cash flows on an ongoing basis will also result in volatility in net assets and income. Finally, operating cash flows will improve because lease payments will now be classified as financing activities rather than operating activities. For lessors, cash flows from operating leases will now be recognized, under both Performance Obligation (PO) and Derecognition models, as receivable at the inception of the lease. As such, the balance sheet will grow under the PO model and financial ratios will change.

These changes could affect loan covenants, financing deals and even regulatory requirements. Companies, particularly those providing success-based incentives, may also need to reassess whether some formulas used in reward calculations will remain appropriate.

Because the ED would require reassessing lease assumptions on an ongoing basis, a company may need to establish policies and design processes and controls to ensure that reliable input from key departments is promptly gathered, analyzed and processed.

Companies should also consider whether current information systems are sufficient. Some may opt to customize their systems; others may choose to purchase integrated software that may be developed by vendors as the ED advances to a final standard.

The ED will also affect structuring of lease contracts. For example, shorter leases will have less impact on initial balance sheet grossing up and on long-term volatility of financials.

However, inclusion of renewal options may still require the leased asset/liability to reflect the impact of such option periods. If options are not included, the lessee will likely be concerned with their “asset security” position. Lessees should balance the financial statement implications of short-term leases with the cost of constantly renewing these arrangements. Lessors, on the other hand, would bear the risks of higher financing costs and non-renewal of short-term contracts. In an effort to cushion the effect of the ED, some companies may consider modifying existing lease contracts; others may explore buying assets instead.

Certain industries like independent power producers and semiconductor companies have build-operate-transfer, build-operate-own or similar contracts that may contain lease arrangements that are currently classified as operating leases. Under the ED, these contracts should be revisited and will likely result in bulking up of the balance sheet. Given the context under which these contracts are entered into (i.e., long-term project finance-type infrastructure project), any grossing up of balance sheet line items will probably affect sensitive financial ratios of existing loan covenants.

Certain lessors specializing in operating leases, like car leasing companies, may have to review business models as customer or lessee preference may shift given the proposed on-balance sheet recognition of all leases.

As entities structure new leases or modify existing ones, the current and deferred tax implications should be considered in light of the new ED. Assessing tax implications early on would help companies reduce tax risks.

Once finalized, the new standard will be applied to all leases existing as of the date of initial application. If the proposed standard takes effect in 2013, then all leases outstanding as of Jan. 1, 2012 will have to be reviewed.

This might require much effort and resources because some leases are already long-outstanding, and some entities do not maintain a repository of contracts that can provide the information needed for the transition. Entities should consider gathering lease-related information on a real-time basis.

At present, the ED is not yet final and more changes will most likely arise based on the continuing deliberations by the IASB and the US Financial Accounting Standards Board.

However, the proposed on-balance sheet treatment will likely be kept. Companies are therefore encouraged to assess the impact of the ED early on. Understanding the ED better will help firms prepare and plan for the transition, presumably in a way that will help address both accounting and tax concerns.

In view of the proposed on-balance sheet treatment of all leases, how does one now draw the line between a leased asset and an owned one, from a financial reporting standpoint? With the current IAS 17, firms deal with the issue on how to structure and classify leases (i.e., either operating lease or finance lease), given that IAS 17 allows an off-book treatment of operating leases. But with the ED, such a distinction will soon disappear and with it, much of the lease structuring opportunities. What used to be a major accounting issue that arguably overshadowed its financing implications has now redounded to a cash flow concern.

So, would it now be better for one to just buy rather than lease? Soon there might not be much of a difference.

(As of publication, John T. Villa is an Assurance partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.