Research by PricewaterhouseCoopers* and Rotterdam School of Management , Erasmus University : Company leverage increases significantly as a result of proposed new lease accounting

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Amsterdam, 14 October 2009 -In March 2009, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) issued a Discussion Paper proposing a new model that would significantly change lease accounting for lessees, including the elimination of operating leases. Under this proposal, the current distinction between operating leases and finance leases will be eliminated and all leases will be accounted for on balance including existing operating leases that are now accounted for off balance

The comment period for the Discussion Paper ended on 17 July 2009. Some 290 comment letters were received. Since then, the boards have been evaluating the feedback received and will deliberate in expectation of releasing an exposure draft in mid-2010 and a final standard in 2011.

Research completed by PricewaterhouseCoopers and the Rotterdam School of Management in the Netherlands has quantified the minimal impact of the proposal on financial ratios reported by companies worldwide. The expected impact of the proposed changes to lease accounting is that the reported interest bearing debt, leverage and EBITDA will increase, for certain companies this increase will be substantial.

Based on the operating lease disclosures in financial statements of some 3,000 companies worldwide, they expect that the reported interest bearing debt of these companies will increase an average by 58%. This is a cautious estimate as only the impact of capitalizing disclosed operating leases is quantified in the research. The impact on companies' debt can be higher depending on the specific details in a final standard. The average impact on debt balances is influenced by a number of companies that will see a large relative increase in debt. Nevertheless, 24% of the companies will see an increase in their debt balances of over 25% based on this research.

The research also shows that the impact on financial ratios differs significantly per industry. Industries that will see the highest impact on reported financial ratios are:

  • Retail and Trade;
  • Professional and Other services;
  • Transport and Warehousing;
  • Accommodation; and
  • Telecom.

For retail companies, the reported debt balances are expected to increase by an average of 213% and the leverage (calculated as interest bearing debt divided by equity) will increase by an average of 64 percentage points. Approximately 71% of the retail companies will see an increase of reported debt balances of over 25%.

The research also shows that the impact on individual companies within an industry can be significantly different depending on the size of the company and country of residence. Companies in the Netherlands are expected to see an average increase in leverage of 27 percentage points which is the largest increase. This may result in a competitive disadvantage for companies in the Netherlands compared to their peers in other countries.

The proposal will also result in an increase of EBITDA (Earnings Before Interest Tax Depreciation and Amortization). EBITDA is expected to increase as rent expense will be replaced with interest and amortization expense, which are below-the-line charges. The companies in the research will see an average increase in EBITDA of 18%. For companies in the Netherlands this increase is slightly higher and amounts to 27%. The economic downturn resulted in a lower 2008 EBITDA for many companies. As a result, this increase in EBITDA in 2008 might not be representative for the actual increase upon a final standard.

Analysts, credit agencies and banks currently adjust financial statements for off balance operating leases using various rules of thumb. A frequently used rule of thumb to estimate the lease liability and to adjust financial statements is based on a multiple of 7 applied to the annual rent expense. This rule of thumb is based on an average remaining lease term of approximately 7 years.

Whether this rule of thumb, as an approximation of the lease liability used to adjust financial statements for off balance operating leases, is reliable can only be concluded upon issuance of a final standard. Companies' stock prices and access to capital may be impacted if the conclusion is that the rule of thumb historically used was not reliable in estimating the actual adjustment to the financial statements.

The research compared the adjustment to companies' debt as a result of capitalization of off balance operating leases with the results of the rule of thumb. This comparison shows that for 93% of the companies the rule of thumb of 7 times the rent expense resulted in an overstatement of debt balances. The actual impact on financial ratios will depend on the details in a final standard for lease accounting. A final standard may likely require leases capitalization based on a most likely lease term approach as opposed to the contractual lease term. This might tend to lengthen the accounting lease term beyond that determined under existing lease accounting standards. The resulting adjustment to financial ratios for off balance operating leases might be significantly higher under the most likely lease term approach. In this scenario, the adjustment to companies' debt will increase and may even be higher than the rule of thumb. Companies that will report a larger increase in debt than the rule of thumb applied by analysts, credit agencies and banks should be concerned, especially if their peers in the industry are not.

Existing leases are not expected to be "grandfathered" when the final standard is issued. Companies are encouraged when negotiating new leases to consider the implications of both the existing and proposed new standard.

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