The corporate impacts of changes to lease accounting rules will not be factored into ratings issued by Fitch, the agency has revealed. In a 29 February statement, the organisation said that the changes – contained in new, global standards IFRS 16 and ASC 842 – will play no intrinsic role in its judgements, as any new balance-sheet burdens would be offset by key advantages.
“In our analysis of operating leases,” Fitch explained, “we capitalise the annual charge using a multiple to create a debt equivalent. This represents the estimated funding level for a hypothetical purchase of the leased asset. The new accounting rules for leases take a different approach, requiring companies to include the net present value of all future lease payments.”
It added: “The new approach reflects companies’ legal commitment under their leases, but we believe ours is a better reflection of the economic reality of these transactions. When the asset being leased is fundamental to the continued operation of a company, we generally expect that company to use it for its full economic life.”
Fitch said that the multiple “replicates the debt needed to fund the asset over that lifetime”, and as such, acknowledges the likely renewal of the lease. “The contractual minimum approach,” it said, “does not necessarily capture the permanent nature of these assets, especially for regularly renewed, short-term leases. We therefore expect to continue adjusting companies’ reported figures to create a debt equivalent.”
Each of the two, new standards was created to ensure that corporate accounts would give a more rounded picture of firms’ financial activities – broadening the scope of what had to be declared, so that assets previously be left off the balance sheet were mandatory for inclusion.
According to Hans Hoogervorst – chairman of IFRS 16 watchdog the International Accounting Standards Board – the changes will “provide much-needed transparency on companies’ lease assets and liabilities, meaning that off-balance-sheet lease financing is no longer lurking in the shadows”.
Ever since the standards were approved, corporate finance departments have been wrestling with the potential effects of the rule changes on treasury and other, core functions. However, the Fitch announcement means that they now have one less issue to worry about.
Indeed, Fitch is positively sanguine on the more visible presence that leases will assume in firms’ financial records. “The inclusion of operating leases on the balance sheet may make some companies reconsider their use,” it said, “but these instruments have other potential advantages over direct ownership.”
For example, it pointed out, operating leases can enhance flexibility: in cases where a business line has yet to establish itself, the lease obligation can be exited if the line ceases. Furthermore, leasing can provide breathing room for reducing or increasing assets in line with the business cycle.
“Operating leases also alleviate refinancing risk,” Fitch added, “as the funding profile is effectively amortising rather than bullet repayments. But unlike an owned and pledgeable, balance-sheet-funded asset, no asset is owned at the end of the operating lease.”
The agency concluded: “The new reporting standards will result in higher reported leverage, but we do not think there is a significant risk of borrowers breaching loan covenants. Many covenants will continue to be tested under the accounting rules in force when the covenant was agreed.”
For further details on the rule changes, read Henry Wilson’s in-depth feature here.