Economic Impacts of the Proposed Changes to Lease Accounting Standards
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Executive Summary
Capitalizing operating leases will add an estimated $2 trillion -- and 11% more reported debt -- to the balance sheets of US-based corporations
The front loading of lease interest expenses would act as a 9.6% surcharge1 and would result in an aggregate reduction in pre-tax net income of 2.4% in the first year of the new regime
The changes may increase the cost of leasing (through a de facto increase in the cost of debt) which could negatively impact GDP and jobs. A 50 basis point increase in the cost of debt translates to a potential $10 billion in lost GDP and 60,000 less jobs by 2016
The proposed changes could result in a permanent reduction of $96 billion in equity of US companies
Most companies, across a wide spectrum of industries, lease equipment or real estate as part of their day-today operations. These operating leases grant lessees access to vital assets, typically at a lower overall cost when compared to directly purchasing those assets. Since lessees do not assume ownership of the assets, the value of these leases currently does not appear on a company’s balance sheet. Instead, future lease obligations are reported in the footnotes to a company’s financial statements.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have proposed a new model that would transform lease accounting. Under the proposed rules, operating leases, which are currently treated as rental expenses in the income statement, would be capitalized (as both a liability and an asset) and added to the lessee’s balance sheet. Correspondingly, rental expenses on the income statement would be replaced with implied interest cost and amortization of the capitalized asset, which will create a front loaded cost pattern that is permanent. Additionally, some valued lessor accounting products that reduce the cost of leasing to lessees will be impacted – leveraged lease treatment will be eliminated and sales-type lease gross profit recognition will be deferred.
The front-ended cost pattern will have a permanent impact for companies that lease assets – that is it will lower lessees’ earnings, reduce capital, and create a deferred tax asset. In addition, it will cause a revenue/expense mismatch for lessees that get revenue from reimbursement of rent paid under operating leases as in Medicaid/ Medicare and cost plus contracts. Their lease costs will also rise due to the changes in lessor accounting that impact lease pricing. Their balance sheet dynamics will change permanently with more assets (capitalized leases and deferred tax assets), more debt (capitalized lease obligations) and less equity reported.
The transition to the proposed accounting regime will usher in a period of adjustment and uncertainty. The new rules will alter many key financial metrics that investors use to determine company valuations and credit agencies use to determine credit worthiness. For example, metrics such as Gross Margin, Cash Flow from Operations, and Earnings Before Interest and Taxes (EBIT) should improve. Reported Interest Coverage and Return on Assets (ROA) would be lower under the new rules. Industries that make extensive use of operating leases, such as Retail, Transportation, Banking and Telecommunications, will be the most affected as investors and credit agencies seek to re-calibrate the metrics they use to determine valuations, peer-to-peer performance comparisons, credit worthiness, capital requirements and so on. The companies most affected have gone on record stating they will try to offset the negative financial impacts by cutting costs, reducing capital expenditures and inventories, and passing on increased lease costs to customers. They will also look to restructure future leases to lessen the impact of the new accounting regime. These issues will have an impact on the overall economy, some of which we can measure and predict but some of which will become evident only after the changes are implemented.
The implications of the new rules transcend simple changes to statements of financial position. In fact, following FASB/IASB’s release of an Exposure Draft in August 2010, approximately 800 letters were submitted during the ensuing comment period. While the majority of respondents did not object to capitalization of the operating leases – indeed, many thought it was a good idea – their letters expressed concerns over the confusion associated with a transition to the new model, the cost of the information technology (IT) systems and staff required comply with the new rules, how to account for lease renewal options, how to treat service contracts, and so on. The letters also pointed out some potential unintended consequences of the new rules such as the triggering of existing debt and lease covenants (due to changes in lessee debt levels and the front ending of reported lease costs) that are calculated based on GAAP as it exists today.
Perhaps the most significant unintended consequence of the new regime could be a shift in the lessor-lessee dynamic. This could translate to more protracted lease negotiation processes as both lessees and lessors seek to maximize their individual accounting benefits under the new regime. For example, if the perceived advantages of long-term leases are diminished, lessees may:
- Opt for shorter lease terms;
- Seek to increase contingent portions of their leases, thereby reducing the amount that is capitalized;
- Negotiate for the elimination of renewal options and contingent rents based on an index or a rate that require monitoring and complex negative adjustments to their financial statements;
- Opt to buy assets rather than lease.
By reducing the depth and duration of lease commitments (or foregoing leases altogether) these lessee strategies have the effect of increasing risk for lessors, which, in turn, could cause lease prices to rise. The Equipment Leasing & Finance Foundation commissioned IHS Global Insight to examine the potential economic impact of the proposed changes to lease accounting. In doing so, we conducted a qualitative review of the literature on the proposed changes, primarily focusing on reports published by the large accounting firms. This was supplemented with an analysis of a representative sample of the comment letters. This research help inform a multi-stage quantitative assessment of the economic impact of the proposed rule changes.
Our analysis found that, had operating leases been capitalized effective 20102, $2 trillion of capitalized assets -- and a correspondingly large debt liability – would have been added to the balance sheets of US corporations. For the aggregate US economy, the frontloading of those lease costs would take until 2015 to reverse direction. For industries and companies that are heavily dependent on long-term leases, the reversal timeframe may be much longer. This analysis does not reflect the impact of new leases added in subsequent years. Thus, we anticipate the new accounting model will have a long-term, negative impact the equity companies report on their balance sheet.
In the first stage, we analyzed the financial data on over 1,800 US-based, publicly traded companies from CompuStat, including the footnoted operating lease data. This was combined with IHS’s proprietary macroeconomic data to assess the impact on industry-level financial statements for the entire US economy. This analysis yielded an estimate of approximately $2 trillion in operating leases would have been added to the balance sheets of US companies had the rules been implemented in 2010 (the most recent year for which annual data was available), assuming all leases in existence are capitalized. If the new rules were initiated in 2010, after tax reported earnings of US companies would have declined by $32.3 billion or 2.4% due to the front ended cost pattern.
Table of Contents:
EXECUTIVE SUMMARY
- How the New Operating Lease Accounting Rules Will Impact Equity
- Guide to This Report
A QUALITATIVE ASSESSMENT OF THE OPERATING LEASE ACCOUNTING CHANGES
- Implementation Costs
- Front-loaded Cost Schedule
- Other Concerns
ECONOMIC IMPACT ASSESSMENT
- Economic Impact of Contraction in the Equipment Leasing Industry
- Economic Impact of Increasing the Cost of Debt
- A Closer Look at Ten Companies
- Retail: Walgreen Company
- Retail: CVS
- Retail: Walmart
- Financial Services: Citigroup
- Healthcare: Five Star Quality Care
- Transportation: United Continental
- Transportation: Delta Airlines
- Transportation: FedEx
- Manufacturing: ExxonMobil
- Information: AT&T
APPENDIX A: INDUSTRY-LEVEL FINANCIAL STATEMENT SUMMARIES
APPENDIX B: METHODOLOGY STATEMENT
- Estimating the Capitalized Value of Operating Leases in the United States
- Calculating the Steady-State Impact on Industry Equity
- IMPLAN Model
- IHS Global Insight US Macroeconomic Model
