New international accounting rules will give a better indication of the economic substance of leases, but could give companies an incentive to change the way lease deals are structured so they remain off balance sheet, says Fitch Ratings.
In a special report, entitled
‘New Global Proposals to Reshape Lease Accounting’
, the credit ratings agency (CRA) says that the new standards will require that all leases with terms of over 12 months are brought on-balance sheet. This will aid analysis as the CRA views longer-term leases as debt-like obligations and routinely adjust debt metrics to enable comparison of different financing models.
However, Fitch adds that it is vital that information about cash rentals and the nature of leased assets remains available to ensure adjustments can be made if necessary. If companies did manage to keep any leases of longer-term assets off the balance sheet, robust disclosure will be essential so that analysts can still adjust key metrics.
There are several ways that companies might try to structure arrangements to keep leases off the balance sheet. These include switching to a lease with a term of less than 12 months. The rules attempt to limit the appeal of this exemption by including renewal options within the 12 month period. Short-term leases might be a disadvantage because they create uncertainty over the future availability of the asset, but this could be less of a deterrent where contractual commitment for a longer period is not essential.
Companies may also try to replace leases with contracts that give them access to a desired service without giving them rights over a specific asset. Since leases are defined as providing an identified asset that the lessee controls, these service contracts could remain off-balance sheet. This might be achieved by something as simple as giving the lessor the right to substitute an asset at will for a similar one, which may have little operations impact for either party.
Fitch adds that the explains how the CRA assesses leases in its analysis and how it will approach the changes proposed by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). An effective date for the new standards has not yet been proposed, however, it does not expect them to become effective prior to 2017.
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