For many years companies have financed significant portions of their operations by leasing buildings, machinery, manufacturing equipment, trucks, railcars, office space, office equipment – desks, chairs, computers, copiers, etc.
Leasing provides an effective way for a growing enterprise to preserve its working capital and avoid risks related to obsolescence and residual value. Another benefit: leases are easily structured so that lease assets and liabilities do not appear on the balance sheet. That allows a company’s operating performance to appear more efficient than a similar company that buys or owns such assets.
Change is Coming to Accounting for Leases
Because of these benefits, leasing has grown to be a significant part of the economy--particularly for entrepreneurial middle market businesses. Virtually every company – large and small - leases something, and some entities lease significant portions of their operations. Various events have raised criticism of the off-balance sheet treatment of leases. The recent great recession was the final straw that seems to have pushed the FASB (US) and IASB (International) accounting boards to revise rules on accounting for leases. But widespread, entrenched leasing practices have made creation of a new standard challenging. So far it has taken over six years—and the boards are now on their third attempt at revision. Whenever it arrives, the new standard will include changes in expense recognition as well as the requirement that lease assets and liabilities be recorded on the balance sheet. These balance sheet and income statement changes will have an impact, generally negative, on several key financial metrics used by analysts to measure company financial performance.
Many predict we’ll see the new standard within a year, though the effective date won’t be immediate and the FASB and IASB may not have the exact same rules. But both boards have consistently reconfirmed they will require a lease assets and liabilities on the balance sheet. Newport Board Group will continue to monitor these developments.
What to do now?
Financing costs are still historically low so lease interest cost is also low and would generally indicate leasing is still a good option. When the new rules are finalized the likely effective date will be two or three years from that date – say 2017 or 2018 at least, and probably later for private companies. That means there will be ample time to prepare. But don’t underestimate the time it may take to accumulate the data needed for restatement of financial statements and setting up new accounting systems. Several companies I know have begun the process and were surprised by the amount of effort required. Much of the data for impact analysis and potential restatement under the new rules was never kept since most leases followed a cash paid expense policy.
If you have debt or other financial covenants regarding EBITDA coverage or total debt-equity ratios, you might ask the lender for an exemption for the effects of new accounting rules after the date of the agreement. We’ve seen that a number of companies would have failed their covenants under the latest proposed rules.
When it’s appropriate, companies should undertake an assessment of the new lease rules. A project team can design an analysis of the lease portfolio and identify the accounting impact, impact on key financial ratios, and information required for the new accounting disclosures. We expect that accountants and bankers will need training to understand if/how the new rules truly impact the economics of the business.
CEO’s and private company boards might be particularly interested to ask an adviser or board director to help oversee a project team designated to analyze the impacts. Support staffs of private companies are generally smaller and less able to assume the extra workload to implement the changes. Anticipation and early communication among accountants, management and outside parties will minimize disruption and actually enhance relationships with lenders and other stakeholders.
Meanwhile, companies that want to conserve working capital to finance operations and growth will continue to look to leasing and other financing techniques that enable them to turn their balance sheet faster. The changes in accounting for leases won’t diminish the opportunity that private equity and other investors continue to see in the very vibrant financial services segment of the business services industry.
About the Author
Charlie brings to Newport significant experience in financial reporting and operations of financial services companies, manufacturing and telecom entities, among others. He has extensive experience in public company reporting, international business, debt and capital market activities, and operational change. During his career, he also served two years as a FASB Fellow leading the areas of lease accounting and real estate reporting issues. Contact Charlie Here.
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