Treasury Today Country Profiles in association with Citi

New leasing regulations could push up borrowing costs

Over a decade ago, in the wake of the Enron debacle, regulators wanted to find new ways to account for leasing, to get those assets and liabilities back onto the balance sheet. Now, after 14 years of debating the issue, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are close to reaching an agreement.

The two agencies are planning to publish an exposure draft of a new regulation governing leasing for International Financial Reporting Standards next month. A final determination is due by June 2011, but that depends very much on how the debate over the exposure draft runs. This is no minor or technical accounting debate: large sums are at stake.

There are also changes in the level of tier 1 capital available to the leasing companies when they apply the new capital regulations (lessors are often part of major banks, but even those that are not must justify sufficient capital under most national regulations) – that calculation is affected under Basel III. As Jacqueline Mills, an analyst at the European lessor trade organisation Leaseurope points out, “These changes will affect almost all businesses given that there are very few firms who do not lease or rent equipment or property at some point in time.” Mills warns that the IASB-FASB proposals could lead to a sharp increase in borrowing costs for businesses.

In most national accounting systems, operating leases don’t have to be reported on corporate balance sheets, although analysts often make a kind of adjustment for them when they crunch the numbers, and companies will often produce ‘adjusted’ numbers in their presentations to investors. But there is always difficulty in determining the difference between financial and operating leases. There is also a wealth of related technicalities that need to be taken into consideration. Leasing is a complex area.

With the new regulation, leases would be considered in terms of “rights of use” for the equipment that the company is paying for. The object is to eliminate the distinction between financial and operating leases; when you lease equipment or property, you obtain the right of use in exchange for paying rent and interest. The right of use is accounted for on a cost basis, and interest payments are considered separately. After some years of debate, FASB has also come to accept this approach.

Market analysis

The majority of lessees seem willing to adopt this approach. Says Stuart Siddall, Chief Executive of the London-based Association of Corporate Treasurers, “The ACT is in agreement with your overall approach of recording the asset based on a right of use concept and a liability for the obligation to pay rentals.” But the ACT points out that the devil is very present in the details, with a whole list of reservations about specifics involving contingent rentals, residual value guarantees and options, to name a few.

Lessors are very unhappy about this approach. As Leaseurope points out, term leasing covers a wide range of contracts that need to be distinguished. Different contracts demand different activities, and hence there are different lessor types with appropriate experience and skill sets providing these products and operating in diverse markets. Many lessors feel that the IASB-FASB approach doesn’t take much of the reality of the leasing industry into consideration.

Then there is great concern in the European and Asian leasing industries that the new regulation will be difficult to incorporate into national law. Many national law codes, as for example in France, don’t make the traditional Anglo-Saxon distinction between operating and financial leasing. “The English word ‘leasing’ covers all kinds of business we consider under that activity,” explains Vincent Rupied, International Director of Corporate Relations at vehicle lessor Arval. “In France, however, there are different words for traditional leasing and operating leasing, and no specific distinction for financial leasing. Needless to say, if these distinctions all changed in law it would have a serious impact on the industry!”

There is also concern, among treasurers, for what IASB calls the ‘subjective’ element in the new regulations. Leases for offices, for example, would not only have to be put on the balance sheet, but their value would be determined by an estimate of how many years the company intends to use the property for. If that estimate changes, then the value of the lease changes as well. The need for attention to this kind of detail worries both the ACT and Leaseurope.

George Lynn, CFO, Angel Trains, London, says: “It’s great that the long debate between IASB and FASB over this issue has come to an end. FASB wanted to take a terribly simplified approach, and IASB’s take was a bit academic, but they’ve reconciled the two, and that is good for all of us. With the ‘rights of use’ approach, the impact on corporate balance sheets should not be drastic, and long-term stability should be the result. It is to be hoped that IASB and FASB will succeed in ironing out some of the complexities and technical details before the regulation is finalised.”

treasurytoday insight

As the Enron scandal showed, leasing has been a ‘grey’ area for far too long. It seems fairly certain that, despite the opposition from lessors, who will have to adjust their business models, the ‘rights of use’ approach will prevail. While the changes under the new regulations are not drastic, they do oblige financial officers to pay much more attention to leasing than they had to in the past, so close attention to the way the regulation is finalised is key.