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Foundation Warns Against Lease Accounting Proposals

by Mike Godfrey,, Washington

15 December 2011

The Equipment Leasing and Finance Foundation has warned against proposed amendments to financial reporting requirements for leasing transactions, which it says could cost the US economy USD10bn in lost GDP and 60,000 less jobs by 2016.

Most companies, across a wide spectrum of industries, lease equipment or real estate as part of their day-to-day operations. These operating leases grant lessees access to vital assets, typically at a lower overall cost when compared to directly purchasing those assets. Since lessees do not assume ownership of the assets, the value of these leases currently does not appear on a company’s balance sheet. Instead, future lease obligations are reported in the footnotes to a company’s financial statements.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have proposed a new model that would transform lease accounting. Under the proposed rules, operating leases, which are currently treated as rental expenses in the income statement, would be capitalized (as both a liability and an asset) and added to the lessee’s balance sheet. Correspondingly, rental expenses on the income statement would be replaced with implied interest cost and amortization of the capitalized asset, which will create a front loaded cost pattern that is permanent. Additionally, some valued lessor accounting products that reduce the cost of leasing to lessees will be impacted – leveraged lease treatment will be eliminated and sales-type lease gross profit recognition will be deferred.

The Foundation says that the front-ended cost pattern will have a permanent impact for companies that lease assets – that is it will lower lessees’ earnings, reduce capital, and create a deferred tax asset. In addition, it will cause a revenue/expense mismatch for lessees that get revenue from reimbursement of rent paid under operating leases as in Medicaid/ Medicare and cost plus contracts. The Foundation furrther warned that their lease costs would also rise due to the changes in lessor accounting that impact lease pricing. For companies that lease assets, their balance sheet dynamics will change permanently with more assets (capitalized leases and deferred tax assets), more debt (capitalized lease obligations) and less equity reported.

Warning against the change, the Foundation said capitalizing operating leases would add an estimated USD2m – and 11% more reported debt – to the balance sheet of US-based corporations.

The front loading of lease interest expenses would act as a 9.6% surcharge and would result in an aggregate reduction in pre-tax net income of 2.4% in the first year of the new regime

Further, the changes may increase the cost of leasing (through a de facto increase in the cost of debt) which could negatively impact GDP and jobs. A 50% increase in the cost of debt translates to a potential USD10bn in lost GDP and 60,000 less jobs by 2016, the Foundation said.

In addition, the proposed changes could result in a permanent reduction of USD96bn in equity of US companies.

“The transition to the proposed accounting regime will usher in a period of adjustment and uncertainty. The new rules will alter many key financial metrics that investors use to determine company valuations and credit agencies use to determine credit worthiness,” the Foundation said.

“For example, metrics such as Gross Margin, Cash Flow from Operations, and Earnings Before Interest and Taxes (EBIT) should improve. Reported Interest Coverage and Return on Assets (ROA) would be lower under the new rules. Industries that make extensive use of operating leases, such as Retail, Transportation, Banking and Telecommunications, will be the most affected as investors and credit agencies seek to re-calibrate the metrics they use to determine valuations, peer-to-peer performance comparisons, credit worthiness, capital requirements and so on. The companies most affected have gone on record stating they will try to offset the negative financial impacts by cutting costs, reducing capital expenditures and inventories, and passing on increased lease costs to customers. They will also look to restructure future leases to lessen the impact of the new accounting regime. These issues will have an impact on the overall economy, some of which we can measure and predict but some of which will become evident only after the changes are implemented.”

“The implications of the new rules transcend simple changes to statements of financial position. In fact, following FASB/IASB’s release of an Exposure Draft in August 2010, approximately 800 letters were submitted during the ensuing comment period. While the majority of respondents did not object to capitalization of the operating leases – indeed, many thought it was a good idea – their letters expressed concerns over the confusion associated with a transition to the new model, the cost of the information technology (IT) systems and staff required comply with the new rules, how to account for lease renewal options, how to treat service contracts, and so on.”

“The letters also pointed out some potential unintended consequences of the new rules such as the triggering of existing debt and lease covenants (due to changes in lessee debt levels and the front ending of reported lease costs) that are calculated based on GAAP as it exists today.”

“Perhaps the most significant unintended consequence of the new regime could be a shift in the lessor-lessee dynamic. This could translate to more protracted lease negotiation processes as both lessees and lessors seek to maximize their individual accounting benefits under the new regime.”

TAGS: tax | business | interest | law | accounting | United States | financial reporting | Financial Accounting Standards Board (FASB) | regulation

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