Lease Accounting: US lessees express unease

A survey of US lessees shows considerable concern at coming changes in the lease accounting rules.

The survey, Proposed New Lease Accounting Standards: the View from Corporate Finance, was undertaken by the market research group Ventana Research. It was jointly commissioned by Financial Executives Research Foundation (FERF), the research arm of Financial Executives International – a professional body for accountants in corporate practice which has been critical of the standard setters’ proposals – and Cresa, a lessee advisory firm in US real estate leasing.

The survey, undertaken earlier this year, was based on replies from financial executives in 100 US companies across a variety of commercial sectors. All of those were familiar with the lease accounting proposals, and a third of the companies had initiated formal reviews of its likely impact.

The focus was primarily on lessees in real estate leases, which are predominantly off-balance-sheet to the lessee as operating leases under current rules and will thus be heavily affected by the wholesale capitalization proposal. However, the findings also covered equipment leases, of which a high proportion in the US market will likewise be affected.

As well as answering pro forma questions for which the replies were aggregated, respondents were invited to add comments. These comments show that although most of their companies made use of leasing as lessees, some had different types of interest in lease contracts.

Operating costs

The survey gave some indications of the sheer number of equipment leases that could be affected for individual companies. Among larger companies (defined as those with 1,000 or more employees), 19% of them had 10,000 or more of these leases running. Even among small and medium sized businesses (SMBs) – i.e. all others – 3% of firms had 1,000 or more equipment leases.

In most sectors real estate leases are of course comparatively fewer in number, though of greater overall value. It is therefore on the equipment leasing side that compliance costs of the new rules will be greatest. The survey asked several questions on this.

On general compliance and internal audit costs, 87% of respondents said that new standard would result in greater costs, including 40% of the total who said that this would have a major impact. For external reporting costs, 20% expected a major impact and altogether 80% expected increased costs of some order.

The director of a large multinational manufacturer said: “There will be significant operating costs … The most challenging and costly will be to inventory all leases, which are all over the world, [with contracts] in many different languages and subject to different legal requirements.”

“This would [require] a more centralized leasing function rather than the decentralized structure that exists today.”

This comment was echoed by a director of a large Fortune 100 company who said: “We can easily develop a real estate inventory, because the amounts are significant, the contracts are for long [terms] … and are subject to centralized review … However, equipment leases may be atomized throughout the organization … which will make the transition even more challenging.”

As many as 87% of respondents said they would have to modify their financial reporting and administration systems for leases as lessees; and nearly half of the total said this would have a major cost impact.

Respondents were asked if possible to quantify the total of ongoing compliance costs from the lease accounting change. Among those who did so, the average cost was estimated at 0.62% of total gross revenues, implying significant cuts in operating margins.

This estimate seems extremely high; and over a third of the sample reported that they did not have the necessary information for such a calculation. However, there seems no doubt that the costs will be material.

By weighting the responses to the various categories of compliance costs, the researchers were able to gauge the overall administration cost effects on companies of different sizes. This showed that the largest companies (i.e. those with 10,000 or more employees) would face proportionately the greatest costs, but that it would be very substantial for all who make use of leasing.

Economic impact

The major concern for lessees is how capitalization will affect the shape of their accounts and hence their key financial ratios and ultimately the economic standing of their businesses.

As a measurement of the most direct effect, the survey found that the increase in gross asset values would amount to over 30% for as many as 12% of companies. For the majority (62% of the total) there would be a smaller rise of up to 10% in gross asset values.

Among larger companies, 32% expected the new rules to have a major negative impact on their balance sheet ratios, with 28% expecting a similar (i.e. “major negative”) impact on the overall economics of the business. In terms of industrial sectors, the greatest proportional impacts were found to be in retailing (where the effects principally concern property leases) and airlines (where they of course concern aircraft leases).

Among those respondents who had undertaken formal reviews of the impact, there were divided views as to whether the new rules would have net advantages to investors to balance the adverse effects on lessees. Of these respondents, 38% thought that the change would be advantageous to investors, but 45% thought it would be disadvantageous to them, while the remainder saw no significant change in this respect.

The impact on bank lending covenants of a sudden increase in gross debt through lease capitalization was a concern running through several comments in response. A director of a mid-size construction management company said: “It will clearly be a major challenge to rework loan agreements with lenders to reset the covenants, which will be costly for us as we have multiple lenders and loan facilities.”

A privately-owned franchise operator felt that the bank loan covenant issue would be addressed, at a substantial administrative cost, but was more concerned at the impact on ratios as viewed by less sophisticated users of financial statements, such as its franchise trading partners. On bank covenants, this respondent said: “Banks have seemed to address this topic.”

“Our leveraged calculation has moved to EBITDAR (earnings before interest, tax, depreciation and rent). The lease expense is then multiplied by eight …, which is the standard for our industry, [to derive] … ‘pseudo debt’. Being a private company, the [new] standard … will force [us] to go through the process, time and cost of receiving an opinion from our auditors, just to get back to what banks already have in place …”

One respondent was a Fortune 100 bank which had already evaluated the impact of the proposals. Its comments are to a large extent consistent with the bank borrower perspective quoted above, and confirm that the resulting administrative costs will affect lenders as well as borrowers.

The bank said: “Although balance sheet leverage will increase, the overall credit risk of the customer would not be impacted. A customer’s commitment under [operating] leases … will already have been disclosed by customers [in notes to the accounts] and evaluated by our credit teams. To the extent that a customer has a loan covenant related to balance sheet leverage, we would expect that amendments will be made where the impact is significant.”

“While we currently do not have an estimate of the potential number of such changes or the costs that will be incurred, we do know that there will be incremental burden and costs to work with customers to make changes to their lending agreements …”

P&L expensing

The survey was conducted during Q1 2014. During that period, however, the standard setters’ proposals were significantly changed in respect of the expensing of those operating leases to be newly capitalized, in the profit and loss (P&L) account or income statement.

Prior to mid-March, the two standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) – appeared committed to the proposals in the second exposure draft (ED2) issued last year. Almost all real estate leases (though coming on-balance-sheet) would have been expensed as operating leases are now – i.e. on a straight line basis, presented as a single rental expense. On the other hand nearly all equipment leases would have been expensed like current on-balance-sheet finance or capital leases – i.e. on a front loaded profile, presented as a mixture of finance and amortization charges.

In mid-March this year the ED2 expensing proposals were scrapped, but the two Boards could not agree on a converged alternative. The IASB decided to revert to what had been a converged proposal in the first exposure draft (ED1) in 2010 – i.e. finance lease type accounting for all leases. FASB, however, decided to retain something very close to the current lease classification rules for expensing purposes, so that operating leases would be expensed exactly as they are now (though still going on-balance-sheet).

Some of the survey response comments clearly pre-dated the March decisions, and are therefore now out of date. Among the later comments, however, it appears that FASB’s recent change of proposal affecting operating leases of equipment is welcome among some lessees. A director of a large Fortune 100 company said: “…As FSAB’s tentative decisions stand at this point, the costs required are probably far less than … if the IASB’s proposal [were] adopted …”

“[ED1] was impractical, for both property and equipment; … [ED2] was practical for real estate, but FASB is going on a path that is practical for both real estate and equipment … The IASB, however, is now going back to [ED1] …which many believe does not truly reflect the economics of leasing.”

Some multinational US-based companies have corporate affiliates in jurisdictions following international financial reporting standards (IFRS), and have therefore been following both the FASB and IASB versions of non-convergent decisions. A director of another large Fortune 100 company, with a perspective as both lessee and lessor, suggested that the IASB version of the P&L expensing proposals would fail a cost/benefit test in the case of relatively small value contracts such as typical equipment leases.

This company said: “The [IASB] … proposal would be the most costly for [account] preparers … If you are adding costs to a transaction that is not … very significant …, and which will have little impact on external financial reporting, it would certainly appear that the costs exceed the benefits.”

However, a managing director of one large institutional investor was critical of FASB’s latest decision on P&L expensing. He said: “…[ED1] was more appropriate for [account] users, but as there has been more compromise to satisfy various parties, the emphasis of the proposal has had a negative impact and [the project] is no longer as helpful as it once was …”

Lease vs buy

The study also examined behavioural implications for lessees, including those of “lease versus buy” decisions. One question asked whether potential leases were already reviewed by lessees as capital expenditure projects, and whether this would change as a result of capitalization for financial reporting purposes.

Will lessees review leases as capital expenditure? (% of totals)  Already doing so Will start to review leases as capital under new accounting rules  Will continue not to review leases as capital Equipment leases    Larger companies 38 49 13 Small and medium sized businesses 24 48 28 Real estate leases    Larger companies 43 33 24 Small and medium sized businesses 35 27 38

As the table shows, the response suggests that for equipment leases nearly half of lessees, of all corporate sizes, would in fact change their behaviour, starting to review leases as capital projects for the first time. Of the rest, most larger companies (i.e. those with 1,000 or more employees) were already doing so, although this pattern was not the same for smaller ones.

On property leases the pattern was closer to an even three-way split among those already reviewing leases as capital, those who would continue not to do so and those who would change.

Respondents were also asked about effects on their use of leasing. Nearly half (49%) said that this would not change, but 11% of the total said that they would reduce the use of leasing by over 30%. This question did not distinguish between equipment and real estate; and since real estate leases are mostly not readily interchangeable with outright purchase, it would appear that the implied impact on equipment leases alone might be higher.

A director of a large technology company said: “…This proposal may discourage most businesses from entering into a [relatively] short term lease [of] … three to five years. This will cause a significant shift [towards] purchasing equipment outright. Tying up capital in purchasing assets will limit [other] investment opportunities …”

Finally, one question that seems most pertinent to real estate leases (though it did not distinguish between property and equipment) asked about possible changes towards the use of “short term leases” as defined by the draft accounting standard. These will be excluded from the capitalization requirement; and as the proposals stand now, this would apply to leases that would not be reasonably certain to continue for more than 12 months, in the light of any renewal options.

A quarter of the respondents to this question expected to convert over 10% of their current use of leasing (measured by value rather than contract numbers) to terms of less than 12 months as a result of the new standard.

Written by Andy Thompson of Asset Finance International