The lease bad solution: Proposals to clean up lease accounting will hit many firms’ balance-sheets

The lease bad solution: Proposals to clean up lease accounting will hit many firms’ balance-sheets

Nov 16th 2013 | NEW YORK |From the print edition

ONE of the world’s biggest accountants, PwC, breathlessly bills it as perhaps “the biggest-ever accounting change”. Businesses that lease property and equipment may soon have to start treating the leases as liabilities on their balance-sheets. All sorts of outfits that make heavy use of leasing—from retailers to airlines and, indeed, professional-services firms such as accountants—may end up looking far more indebted than their books currently show. Opponents of the reform predict dire consequences, for the companies and for the economy.When a business borrows money to buy a machine, the loan or bond payments are recorded on its books as a liability, and the machine as an asset. If, instead, it leases that machine, it also gains possession of an asset in return for a stream of outgoing payments; but current rules usually let the firm keep both the asset and the liability off its balance-sheet. It has to add only a brief footnote containing scant details of its overall lease obligations.

After the collapse in 2001 of Enron, an energy-trading company that had used accounting tricks to hide its liabilities, America’s Congress asked the Securities and Exchange Commission (SEC) to investigate all forms of off-balance-sheet financing. Four years later the agency issued a report that identified leases as a giant loophole. It estimated that $1.25 trillion of American businesses’ future lease obligations were missing from their published accounts, and recommended that they be included.

Since then, the world’s two main rule-setters for accounts, the Financial Accounting Standards Board (FASB) in America and the International Accounting Standards Board (IASB) elsewhere, have been drawing up new standards. These require firms to estimate the net present value of their future lease payments—that is, their sum after discounting for the time value of money—and enter it in their books as a liability, rather as if it were a bank loan.

The SEC had predicted that its call for reform would meet with “strong resistance” and it was right. In May the FASB and the IASB issued drafts of their broadly similar new rules, and got a litany of complaints. A group of American trade associations opposed to the changes argues that many businesses will respond by scaling back their operations to maintain their current debt ratios. Somewhat improbably, they reckon this could eventually knock up to 3% off America’s GDP, almost as much as the financial crisis caused.

Less excitable critics think the rule-change is a costly solution to a minor problem. People who read company accounts—equity analysts, credit-rating agencies, banks and shareholders—are all sophisticated enough to take into account firms’ lease obligations when they assess them. The change would force businesses to set up central databases to record every lease of a year or more, even for items such as coffee-machines that are now lumped into branch offices’ petty expenses. In most cases there is no jiggery-pokery behind a company’s decision to lease: it is often just a convenient way of spreading the cost of a vital but expensive asset.

By turning lease payments into a lump-sum liability and putting that on the balance-sheet, the new rules will also remove those instalments from the firm’s EBITDA (earnings before interest, tax, depreciation and amortisation). So this, the most widely watched measure of firms’ underlying profitability, will be flattered. Is this better than the current situation, in which the balance-sheet looks prettier but EBITDA more closely reflects the difference between the firm’s incomings and outgoings?

The vehemence of the opposition suggests companies are worried about more than just hiring a few accountants. If measures of their financial strength, such as the debt-to-equity ratio, end up looking worse, it may raise their cost of borrowing. They could plead that the change is just a technicality, but their lenders may turn a deaf ear. Some firms may find that the rise in their debt ratios puts them in breach of covenants on their existing borrowings, pushing them into serious difficulties.

However, the SEC and other proponents of reform also have some good arguments. Banks and bondholders are being underpaid for the risks they run when lending to firms that use the current lease-accounting rules to hide a lot of what is, in effect, debt. Even sophisticated equity analysts struggle to understand the obscure and complex leasing arrangements some companies engage in, making it hard to put a fair value on their shares. Given the many objections being made, the FASB and IASB may decide on a further round of modification and consultation. But those lobbying against the reform are unlikely to get it scrapped altogether.