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What is the impact of new rules for lease accounting proposed by IASB & FASB?

August 23, 2010 1 comment

(This article is applicable to CFA Level 1 Candidates but is a good review for Level 2 candidates as well.)

A lease (e.g. lease to rent a machine to make widgets) can be reported on the financial statement as a capital lease or an operating lease depending on the accounting standards & the lease classification.  The key difference between the two is that a Capital lease is recorded on the balance sheet but an Operating lease is not… hence liabilities are lower.

IFRS definition:

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

FASB definition: If a lease meets one or more  of the following criteria, it is classified as a capital lease; otherwise it is classified as operating lease.

  • The [lease] agreement specifies that ownership of the asset transfers to the lessee.
  • The [lease] agreement contains a bargain purchase option.
  • The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset.
  • The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

What is the effect of choosing one lease classification type over another?

CAPITAL LEASE

OPERATING LEASE

Which lease reflects better metrics?

EFFECTS ON FINANCIAL STATEMENTS

Assets

Higher

Lower

-

Liabilities

Higher

Lower

-

Net Income (earlier years)

Lower

Higher

Operating

Cash Flow from Operations

Higher

Lower

Capital

Cash Flow from Financing

Lower

Higher

Operating

Total Cash Flow

Same

Same

-

Tax Savings

Higher

Lower

Capital

BALANCE SHEET RATIOS

Current Ratio

Lower

Higher

Operating

Working Capital

Lower

Higher

Operating

Asset Turnover

Lower

Higher

Operating

Debt-to-Equity Ratio

Higher

Lower

Operating

PROFITABILITY RATIOS

Return on Assets (ROA)

Lower

Higher

Operating

Return on Equity (ROE)

Lower

Higher

Operating

In summary, there are very few benefits of classifying a lease as capital lease vs operating lease.  Operating lease acts a means of off-balance sheet financing and perhaps as a way to hide debt.

A good financial analyst should adjust the financial statements by reclassifying operating lease as a capital lease.

The Economist comments on the proposed rule which essentially wants to bring all leases on the balance sheet and eliminate operating leases:

WHEN you lease something—a boat, a warehouse, a machine for making ball-bearings—you agree to pay for it bit by bit over time. So it is like incurring a debt, say the International Accounting Standards Board (IASB) and America’s Financial Accounting Standards Board (FASB). Therefore, it should be on your balance-sheet. This new rule, proposed on August 17th by the two regulators, has shocked companies everywhere. It is up for public comment until December, but could be enacted as soon as June next year.

A survey by PricewaterhouseCoopers, an accounting firm, found that it would add about 58% to the average company’s interest-bearing debt. Not only new leases but also existing ones would immediately be subject to the new rules. On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards. But since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge. Small wonder they are howling.

The new rules’ effects will vary widely. Retailers, who often lease prime property, will take a beating. Airlines, which seldom own their jets, will suffer too. Some businesses, such as utilities, will barely notice. But others will see their apparent return on capital plunge. Many firms will see their debt-to-equity ratio rise and their ability to borrow fall.

Bruce Krasting on ZeroHedge who asks How Much Debt Does the S&P 500 Have? via Mish:

The list of companies with Operating Leases is endless. I would imagine that most of the S&P 500 will be impacted one way or the other.

And here is Mish on whether Corporations are sittings on piles of cash?

Putting two-and-two together I cannot help but wonder if some of this recent corporate “cash raising” exercise is directly related to the proposed new accounting rules. Certainly rule #1 above applies, and for some corporations the window might close in a year.

Thus, it is highly likely some corporations are “raising cash” now, just to be safe, while they still can. That is one plausible explanation for at least a part of the massive corporate debt issuance as of late.

On the other hand, since when has there been any meaningful changes in accounting rules that were not discarded, ignored, or put on the back-burner for years or decades?

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