The Lease Bad Solution

Proposals to clean up lease accounting will hit many firms’ balance sheets.

By turning lease payments into a lump-sum liability and putting that on the balance-sheet, the new rules will also remove those installments from the firm’s EBITDA (earnings before interest, tax, depreciation and amortization). 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.

© The Economist Newspaper Limited, London (November 16, 2013)

5 thoughts on “The Lease Bad Solution

  1. It is hard to fathom the idea that a leased piece of property would be considered an asset of the lessee if the TITLE to the property belongs to the lessor. I feel that a note to the financial statement would suffice as an indication of the payment liability to the company, and put a reader of the financials on notice.

  2. There’s a big connection between business leases, the balance sheet, and getting financing. The balance sheet is one of the things a lender will look at when considering a small business for a loan, and if lease obligations and leased assets are on the balance sheet, they’re going to want to talk about them. Also, by understanding how these changes in accounting for leases might impact businesses, cloud solutions providers now have an additional lever to use with prospective customers – leasing equipment isn’t the way to keep capex off the balance sheet any longer.

    http://coopermann.com/2013/09/12/lease-accounting-rules-small-business-financing-and-the-cloud/

  3. I think it makes sense to change the rules as the current rules are a complete joke. If a lease contract isn’t a commitment to make payments, then what is it? If a commitment to make lease payments isn’t a liability, then what is? And if liabilities shouldn’t go on the balance sheet, then where on earth should they go??? Of course, companies will have to update their lease accounting software, but that’s a small price to pay.

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