All leases - excluding low-value contracts, or those lasting less than a year - are to be brought on to a company's statement of financial position. This end to off-balance-sheet financing is expected to add close to $3 trillion in global liabilities (and the same amount of assets).
The sectors expected to be most affected by this change include retailers with a large amount of property leases, airlines and other transportation companies, and manufacturers leasing large-scale equipment.
Previously, accounting rules allowed companies to distinguish between finance leases, which sat on the balance sheet, and operating leases, which were reported like service contracts - off balance sheet, with the annual rental cost booked on the income statement. These operating leases will now be brought on to the balance sheet, with the assets (the planes, coaches and properties) on the asset side, balanced by the expected future payments on the liabilities side.
The intention is to increase transparency for investors, by giving the market a better understanding of company leverage. The impact of all those sale-and-leaseback deals so beloved by UK plc should be more clearly understood.
The accounting body hopes this will mean investors can spend less time making balance sheet adjustments; that it will improve their ability to compare both lessor and lessee companies; and that it will mean more transparent information on company leases for the market in general. But it will cost, as companies have to put in place new systems, and perhaps new staff, to do the work, including determining the discount rates for calculating a present value of these contracts.
In many cases this will also mean deterioration in a company's debt to earnings before interest, taxes, depreciation and amortisation (ebitda), or simple leverage ratio of assets to shareholder equity. Will this mean companies break their banking covenants? Perhaps not. The IASB has observed that many covenants used adjusted debt figures, which include off-balance-sheet leases. They usually also include clauses protecting the participants from changes to accounting rules. Interestingly, a 2014 US study also suggested that there were cases when such financial ratios would actually be improved by the changes. But company finance directors are hardly going to enjoy the usually negative restatement of these metrics.
Although the rules are intended to give investors a better picture of company leverage, not everyone is impressed. When it comes to airlines, for example, Gerald Khoo, an equity analyst at Liberum, says there are drawbacks to the approach. That is because the minimum committed lease payments on an aeroplane will last for five years, whereas an airline will potentially use that plane for 25-30 years.
Such a one-size-fits-all accounting policy will not, Mr Khoo argues, give investors a full picture of the total of future payments for a company. "It gets you to a higher number, it is still not the right number," he says. Depending on how best practice plays out, there is a risk that the new approach provides investors with less information to take an informed view than the older approach. That is assuming that in the former regime companies included detail on their off-balance-sheet leases, which could be combined with the on-balance-sheet information to get a fuller picture.
It is too soon to judge whether the new rules will provide a net benefit for all types of companies. It does seem possible, though, that reducing the attractions of such balance sheet flattery for big contracts could give investors, and even management, a better picture of the relative value of owning and leasing an asset. What if the public sector was compelled to adopt a similar approach? The private finance initiatives that have been used to build our hospitals and schools could clearly have benefited from a fuller upfront understanding of the costs.
Meanwhile, keep an eye on International Consolidated Airlines (IAG), Stagecoach (SGC) and other companies as they report under the new regime. A switch away from leasing is unlikely. IAG is reportedly looking to increase the proportion of planes that it leases rather than buying outright. But for the non-expert investor, this balance sheet debate is important, if a little dry. One message of the financial crisis was to understand leverage, and these changes could provide the stockpicker with better comparators on which to base their conclusions.
