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Fitch: Lease Accounting Rule Changes Won't Hit Corporate Ratings

March 03, 2016

New accounting rules that will require companies to include virtually all leases on their balance sheets will not affect credit ratings or the approach Fitch Ratings uses in adjusting leverage metrics to take account of leases, the ratings agency has announced.

On Feb. 25, the Financial Accounting Standards Board (FASB) released the Accounting Standards Update (ASC 842), which followed the International Accounting Standards Board's (IASB) release in January of the IFRS 16.

The new standards arrived to concerns in the leasing industry that the rules could reduce the attractiveness of leasing for some corporations, which would lead to increased direct ownership of assets.

Fleet lessors have disagreed with this view.

"If there is one important message for the industry it’s that the changes don't change the operational and financial merits of leasing," Norman Din, vice president of strategic sales with Wheels, Inc., told on Feb. 26.

In the Fitch analysis of operating leases, the firm capitalizes 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.

The new approach reflects companies' legal commitment under their leases, but Fitch believes "ours is a better reflection of the economic reality of these transactions," according to the firm.

"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. The multiple replicates the debt needed to fund the asset over that lifetime and therefore acknowledges the likely renewal of the lease. The contractual minimum approach 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," according to Fitch.

The main difference between the IASB and FASB standards will be seen in the income statement, according to Fitch.

The IASB will require companies to recognize separate amortization and finance costs on leases. The FASB will require this for capital/finance leases, but most operating leases will be able to continue recognizing a single total lease expense.

Separating finance and amortization costs may result in higher reported charges in the early years of a lease, depending on the term of the lease and amortization rate of the leased assets reported under IFRS 16, which may be different from the underlying cash payments.

The inclusion of operating leases on the balance sheet may make some companies reconsider their use, but these instruments have other potential advantages over direct ownership.

Operating leases can offer more flexibility, for example where a business line has yet to establish itself the lease obligation can be exited if the line ceases. Leasing can also provide some flexibility to reduce or increase assets in line with the business cycle.

Operating leases also alleviate refinancing risk, as the funding profile is effectively amortizing 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 new reporting standards will result in higher reported leverage, but we do not think there is a significant risk of borrowers breaching loan covenants," according to Fitch.

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