Significant changes to the manner in which public and non-public business entities account for their lease obligations will soon have to be adopted. There are numerous issues associated with this new accounting standard and the discussion in this article will focus on those issues specifically affecting lessees.
Among other issues:
- The definition of what constitutes a lease changes to focus on both the right to obtain substantially all of the economic benefits of a specific asset and the right to direct the use of that asset.
- The balance sheet presentation of many leases also changes. All leases (other than narrowly defined short-term leases) must be recognized on the balance sheet with a financial lease liability and a non-financial right of use asset. The previous off-balance sheet treatment of operating lease obligations is eliminated.
- Option periods and changes in lease terms must be monitored more closely to determine whether a reassessment event has occurred which would require a change in the accounting.
- Lease disclosure requirements are greatly expanded to include both qualitative and quantitative provisions.
As one can see, lease accounting will become far more complicated for lessees. And remember, the new lease accounting standard applies to all leases which fall under the definition of a lease in the standard, both real estate and equipment leases.
How Will These Changes Affect Leasing Strategy?
The most significant impact of the new lease accounting standard will be a major increase in liabilities that must be recorded on the balance sheet of lessees. This increase could have a negative impact on some of the more important financial ratios incorporated in loan covenants, such as debt to equity. How rating agencies and lending banks consider any possible deterioration in these ratios is a key question. The Financial Accounting Standards Board (FASB) did acknowledge that this could be a consideration and emphasized that the increase in lease liabilities should be characterized as operating liabilities rather than debt.
Also, many debt agreements contain provisions that indicate that loan covenants should be evaluated based upon frozen GAAP (GAAP in place at the effective date of the loan agreement). In that case, any change in financial ratios should not have any impact on loan covenants. However, once lessees have estimated the impact of the new standard, they should be in contact with their lending relationships to make sure that they understand the lenders’ position on the increase in liabilities.
As a side note, the rating agencies and lending banks often make their own estimates of off-balance sheet obligations. It will be interesting to see how these estimates compare to the amounts that are recognized once the new standard is adopted. In the deliberations before the issuance of the new standard, some FASB members offered the opinion that the rating agency estimates significantly underestimated operating lease obligations as a justification for issuance of the new standard.
Certainly, lease versus purchase analyses will become more important and could result in a decrease in leasing activity. But it is difficult to envision any significant decrease in leasing for a number of reasons. Many companies are cash strapped and leasing presents a particularly advantageous form of financing for those organizations that want to minimize upfront cash outlays. Additionally, leasing allows companies the flexibility to relocate more easily to another location or to change to more advantageous equipment types after the termination of the lease. Ownership of real estate and equipment may well inhibit this flexibility.
To be sure leasing strategy may change. Shorter-term leases will result in smaller liabilities that must be recorded. Lessees may also make an accounting policy election to exempt short-term leases (with maximum terms of 12 months or less) from the new standard and account for them on a straight-line basis similar to current operating lease accounting. But there are business tradeoffs and economic considerations in both of these strategies. Shorter-term leases and short-term leases mean more frequent lease renegotiation risk and the possibility of increased leasing costs. Additionally, lessors may not be willing to take on the residual asset risk associated with these strategies or may want increased leasing costs in order to accept this risk.
Will leasing strategy change? Certainly, but only around the edges. Lessees may shorten lease terms a bit to decrease the lease liability. And lessees will be more careful about provisions contained in the lease, such as option periods and how non-lease components in the lease are structured. However, I do not see any wholesale changes to overall leasing strategy. Leasing is much too powerful a financing tool for many entities.