Growth Companies

Readers Sound Off: Are Leases Debt?

On the eve of a new accounting standard, readers vigorously debate whether operating leases can be considered leverage.
David KatzMarch 18, 2014
Readers Sound Off: Are Leases Debt?

With the world’s leading accounting standards setters on the verge of voting in a new lease accounting regime beginning at a meeting on Tuesday, questions remain about whether all leases can be regarded as debt.

Regardless of how that question is answered, it’s most likely that at long last the Financial Accounting Standards Board and International Accounting Standards Board will soon be putting forth a standard that would require all lessees and lessors to record all operating leases on their balance sheets, rather than scattering them in the footnotes of financial statements as they have done until now. As they are today, capital leases would continue to be reported on corporate balance sheets.

Recently, CFO reported that bankers are warning that altering lease accounting could significantly change a borrower’s balance-sheet profile, possibly making it look more leveraged than it actually is. The changes could also worsen the financial ratios that govern a loan’s covenants, to the point where the borrower is in violation of its agreement with the bank.

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The issue of how leveraged companies would appear to their bankers as a result of the proposed standard triggered a bevy of vigorously worded comments from readers, largely circulating around a central question: Are leases debt?

The debate began with a laugh. It was ridiculous that the boards’ proposal would make borrowers’ balance sheet look more leveraged than it is, because all leases already are debt.

I laughed at this quote
“altering lease accounting could significantly change a borrower’s balance-sheet profile, possibly making it look more leveraged than it actually is.”

This is wrong. The truth is, now an intellectually honest measure of debt (commitments under ALL leases) will be on the balance sheet. Substance over form, ALL leases the run more than a year are debt.

As companies come to the realization of the high cost of lease financing they are baling out left and right.

 That comment triggered further mirth from another reader, who noted that FASB started to curb the ability of borrowers to hide debt via the use of leases with a 1976 standard.

I also had a chuckle. All obligations, including short-term rentals, employment contracts, long term leases, loan agreements, pension obligations, joint-venture agreements, everything, can lead to financial trouble including bankruptcy. The accounting rule change does not change the obligations of the borrower Any bank that made loans ignoring these non-balance sheet items deserves what they get.

Years ago, I was researching the rise of lease transactions, and found that indeed borrowers sought out leases to avoid the perceived hit to their leverage. FAS-13 was the first step to close this. One source interviewed S&P and Moody’s as to how FAS-13 would change their ratings. Not at all, the agencies reported. They already capitalized all the lease obligations they could find out about.

A third reader, apparently agreeing with the first two, responded with a definition:

Quite agree with the readers’ comments. A lease is but indebtedness paid through time, not at some, one (otherwise artificial) termination date. Espial

Relying on the notion that an operating lease is an “executory contract,” a fourth reader, apparently representing the lessor side, argued strongly that operating leases aren’t consider debt for the purposes of bankruptcy. “The simple definition that debt is everything owed is too simplistic,” he shot back:

Operating leases are executory contracts. In a bankruptcy scenario executory contracts can be rejected or affirmed. If rejected, the lease is terminated, the lessor gets its asset back and future rent obligations disappear. So the so-called lease obligation is not debt in bankruptcy. Loan covenants that limit debt are there to protect a lender from the borrower incurring other obligations that would become competing claims in bankruptcy and since an operating lessor does not have equal standing to lenders in bankruptcy lenders have not counted operating lease obligations as debt. So it all depends on your definition of debt. The simple definition that debt is everything owed is too simplistic. There should be a distinction in balance sheet presentation between capital lease obligations (which are debt in bankruptcy) and capitalized operating lease obligations. If the FASB chooses to make that distinction then debt covenants will not be impacted by capitalizing operating leases as non-debt liabilities. If they try to lump all lease obligations into one number then borrowers will have to renegotiate covenants as pointed out in the article. Capitalizing operating leases will be the first executory contract that the FASB will have capitalized. They should take care to avoid unintended consequences of calling something debt when it is debt-like.

The argument heated up. Leases are, in fact, “loan shark financing that drives companies toward bankruptcy,” one of the earlier commenters declared.

Substance over form, leases are debt. They are also loan shark financing that drives companies toward bankruptcy. The legal fiction of bankruptcy law has nothing to do with the economic and accounting impact of lease debt.

Finally, two temporizing readers tried to strike a balance between the two extremes.

All comments thus far are correct, but Bill Bosco is *exactly* correct. Differentiation of the disposition of debt and debt-like obligations in bankruptcy (a legal matter, not accounting/reporting) is the distinguishing factor.

That said, as I’ve written and spoken about for the last five years, including directly with FASB/IASB, let’s go ahead and put leases on balance sheet… the credit ratings agencies do so anyway, as above referenced. Let’s just do it the right way, and without undue administrative burden. UNANIMOUS agreement at the last session I participated in up in Norwalk.

Re bank covenants: I really don’t think that is a major issue, except for borrowers “on the bubble”.

Impact of lease accounting will be good and bad
Good – companies will finally be able to answer the question about how many leases they actually have.

Bad – they may not like the answer, neither will the banks (maybe)

Good – leases are debt. The rating agencies have known this for years. Now management will know too that leases are an expensive form of debt as well as a “bet” on the future value of an asset important to their business (or maybe not?)

Bad (maybe) – loan convents could be impacted unless they contain some type of “prior GAAP” language that makes the agreement immune to changes in GAAP. Many agreement already contain prior GAAP language. If not banks maybe willing to adjust tthe agreement for a fee.

Finally, cash flow remains unaffected meaning it will remain as a key measure when it comes to answering the questions, “What is my real debt capacity? Am I over-borrowed?”