Fitch: Lease Accounting Proposal Expected to Challenge Lessors

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By Jason Bramwell

The changes to the guidelines for lease accounting that were proposed in the recent exposure draft from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will significantly alter financial reporting standards for both lessors and lessees, according to Fitch Ratings.

Lessors are expected to face significant challenges in applying the new rules, but the impact on economic fundamentals in the leasing industry will be limited, the global rating agency said on July 17.

The FASB and the IASB are proposing several new changes to the guidelines for lease accounting: FASB Proposed Accounting Standards Update – Leases (Topic 842) and the IASB exposure draft Leases.

The new proposals aim to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations, and the risks to which it is exposed from entering into leasing transactions, according to the FASB.

Off-balance sheet treatment, which would end for most lessees under the terms of the exposure draft, is one of many current incentives for leasing assets, as opposed to purchasing them outright, Fitch said. Other key benefits of leasing, such as reduced capital outlays, lower residual risk, and portfolio management flexibility, will remain in place.

Under current standards for capital leases, lessees recognize lease assets and liabilities on the balance sheet. For operating leases, lease assets and liabilities are not recognized by lessees on the balance sheet.

Under the new proposals, lessees would have to recognize assets and liabilities for the rights and obligations for leases of more than twelve months.

Fitch said the new accounting guidelines may encourage some lessees to shift to short-term leases of twelve months or less, or structure lease agreements as service contracts. This outcome would be a modest negative for lessors, as short-term leases generally diminish the predictability of cash flows for a lessor and reduce flexibility in aligning the duration of funding.

The new lease accounting rules would increase the level of management judgment used by lessors to determine lease assets and discount rates. Additional disclosure around the residual value and interest rates used in the calculations should enhance analytical comparison across issuers.

Because economic effects on lessors will likely be small, no rating actions are anticipated; however, Fitch said it will evaluate any changes in market dynamics that result from the new rules.

In commercial fleet leasing, the biggest effects are likely to be seen on the lessee side, according to Fitch. Lessees may be forced to make changes to their treatment of "right to use" payments on nonproperty leases with terms of more than one year. Fitch does not expect the changes to fundamentally alter customer decisions on whether to lease assets.

The accounting changes may make it more difficult to compare lessors that have different business profiles or asset types. For example, a newer aircraft lessor with a younger fleet might look more profitable than a more established peer because more income from a lease will be frontloaded under the proposed receivable and residual approach. However, the underlying lease cash flows will not change.

According to Fitch, the new standard will generally make lessor accounting more complex. Both income statements and balance sheets will likely require numerous adjustments to analyze the true economics of the business.

Lessors will need to incur additional expenses to analyze, implement, and maintain the new accounting standard. While Fitch expects these costs to be manageable, it may put smaller leasing companies at a disadvantage relative to competitors with greater scale and resources. Lessors have plenty of lead time, with the final rules not expected to become effective until 2017 at the earliest.

At a higher analytical level, Fitch sees the convergence of international and US lease accounting standards as generally positive, as it will make cross-border peer comparisons much more consistent. Fitch also predicts that the changes will contribute to enhanced disclosure for lessors.

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