Fitch Ratings, one of the three leading investment rating agencies, has this month issued a special report describing how its analysts derive implied capital values for lessees’ commitments under off-balance-sheet operating lease (Operating leases: Updated Implications for Lessees’ Credit, August 2013).
This is of course highly topical in view of the current exposure draft (ED) of new converged rules in international financial reporting standards (IFRS) and US GAAP, to require on-balance-sheet reporting of operating leases.
Neither Fitch nor any of its leading competitors have yet returned a formal response to the ED; and indeed there have been hardly any comments returned from the corporate analyst sector at this stage. However, the comments in Fitch’s report imply strongly that additional disclosure requirements for notes to the accounts would fully meet the needs of analysts, without requiring capitalization of all leases on the face of the accounts as proposed by the standard setters. In this it echoes comments made earlier by a representative of Moody’s (AFI report, May 8).
Although it does not specifically argue for or against the ED proposals, the report commented: “Fitch strongly advocates expanded accounting disclosures of historical rental expense and future commitment under operating leases.”
Commenting on the disclosures already required under the existing IFRS lease accounting standard IAS 17, and their wider adoption in recent years principally through the European rules requiring the use of IFRS by EU public companies, Fitch added: “The 2005 move to reporting under IFRS by a vast number of companies around the world has improved minimum disclosure requirements dramatically in many jurisdictions.”
Fitch applies capital valuations of operating lease commitments to all non-financial companies which it analyses for bond rating and credit report purposes. In addition to agreements within the current accounting definition of operating leases, this is applied to other contracts that convey the use of an asset in exchange for fixed periodic payments, if Fitch analysts judge them to be “reasonably similar to operating leases.”
The adjustments are applied to both equipment and real estate leases. Of these two broad categories, real estate leases will account for relatively larger numbers for the corporate sector as a whole, but there are of course many commercial sectors such as transport where the opposite will be true.
Depending on the availability of information disclosed in notes to accounts, for normal valuations on a “going concern” basis Fitch uses one of two alternative methods to derive capital values for operating lease type contracts:
- applying a multiple to the total of rents for the last 12 months; or
- applying discount rates to derive a present value (PV) of forward obligations.
- Given sufficient information, the second method is considered preferable. However, the first has to be used instead where the disclosure of future lease commitments is insufficiently detailed for the forward obligations method.
Where the last 12 months’ rents have to be used, a multiple of eight is currently applied generally by Fitch to companies based in North America, Western Europe, and most developed countries elsewhere. However, a multiple of seven has been used previously at times of higher interest rates; and multiples of seven or even lower are still used for companies based in countries with high inflation and consequently high interest rates.
The report also makes it clear that Fitch analysts may vary the multiplier where there is a strong expectation that a higher or lower multiple is appropriate for the relevant commercial sector or individual company. Therefore lessees with a relatively high proportion of real estate leases within total leases might be accorded multiples above the standard ones for their countries; and conversely for those with higher proportions of relatively short life equipment leases.
The possible alternative use of the forward obligations basis depends on the available data. The current IFRS lease accounting standard IAS 17 requires a breakdown of future minimum operating lease payments into only three time periods from the reporting date – up to one year, one to five years, and more than five years. The corresponding US GAAP standard Topic 840 (formerly coded as FAS 13) has similarly limited maturity breakdown requirements.
However, rules laid down by the Securities and Exchange Commission (SEC) require listed US company lessees to go much further. For reporting periods since 2001 these have required numbers for minimum aggregate lease rentals for each of the next five years, together with a single aggregate for subsequent years.
Fitch analyst Frederic Gits commented: “Companies that we rate will often provide even more detailed projections of committed lease rental payments for all years.”
“Where we have no information beyond the SEC requirements, we are generally able to calculate a PV by assuming that all subsequent years’ payments occur in Year 6, or alternatively by dividing the aggregate remaining payments by the rental expense in Year 5 to determine the approximate duration. Similar analysis is made of data provided for Years 1-5 under IFRS.”
Significantly in relation to the draft new leasing standard, the Fitch report makes it clear that measurement on either basis would include estimates of rentals which were contingent as at the time of lease inception, such as those resulting from optional renewals into secondary lease periods. In connection with the forward obligations method, the report notes: “Public disclosure [in notes to accounts] may report total rents, including contingent rentals … rather than the minimum required lease payments …”
“In the absence of explicit disclosure, analysts can gauge the importance of contingent rents by comparing total rental expense for a single year relative to prior year’s disclosure of the disclosed minimum required payments for that year.”
In order to make the proposed new lease accounting rules more manageable for lessees, the standard setters have excluded most forms of contingent rentals from the draft capitalization rules. Although the latest Fitch report does not comment specifically on this, the importance of contingent rentals in operating leases generally perhaps accounts in part for the lack of enthusiasm among analysts for the current ED proposals. For they can already collect or estimate contingent rental aggregates from disclosures, whereas balance sheet recognition as currently proposed would largely exclude them.
A third method of capital valuation for operating leases is used by Fitch for “recovery analysis” purposes, where it is contemplated that the relevant company will go into some form of insolvency administration. This takes into account the possibility that the lessee may negotiate a termination at a discount, or dismiss uneconomic operating leases in administration by paying damages at less than the full value of the remaining rentals.
Gits said: “In the US, Canada and a number of other countries, operating leases are executory contracts that may be rejected by the administrator or bankrupt lessee, giving rise to a claim for damages that is generally less than the full PV of remaining lease payments. A going concern assumption would produce a valuation of the lease liability far in excess of what would be paid in the administration of the bankruptcy or winding up.”
Under Section 365 (a) of the US Bankruptcy Code, equipment lessors in operating leases have an obligation to mitigate the level of damages where the lease is rejected by the lessee’s administrator, for example by offsetting current market rentals for the used equipment. Recoveries by real estate lessors in these circumstances are more specifically limited by reference to rents and periods. Fitch’s recovery basis valuations take account of such factors.
The key ratios
Principally there are two ratios derived by Fitch analysts on the going concern basis, having calculated “lease-adjusted debt” allowing for off-balance-sheet operating leases:
- Lease-adjusted leverage ratios. Rental payments (R) are added back to EBITDA (i.e. earnings before interest, tax, depreciation and amortization) to produce EBITDAR, and the ratio measures lease-adjusted debt in relation to EBITDAR. Similarly, lease-adjusted debt plus preferred stock is divided by funds from operations (FFO) plus rental expense and preferred dividends to calculate FFO lease-adjusted leverage;
- Lease-adjusted coverage ratios. Total rental expense is added to interest expense, and the related coverage ratio is calculated as EBITDAR divided by the sum of interest and rent. Similarly rental expense and preferred dividends are added to interest expense, and the FFO fixed charge coverage ratio is calculated as (FFO plus interest, rents and preferred dividends) ÷ (interest, rents and preferred dividends).
The Fitch report includes some analysis of the effect of operating lease adjustments on leverage ratios among a large sample of 478 industrial companies whom it rates (after excluding some outliers such as companies with negative EBITDA). They found that lease adjustment made a significant difference for about a third of all companies. Significance for this purpose was taken to be a difference of 0.5 or “half a turn of EBITDA”, where the ratio of lease-adjusted debt to EBITDAR was compared to that of unadjusted debt to EBITDA.
By Andy Thompson