Corporate Leasing

Today, corporations struggle with economic uncertainty. Maintaining profitability, cash flow and a company's vitality challenges financial managers continuously. This essay portends substantial change on the horizon, specifically surrounding lease arrangements and the dramatic impact of associated financial reporting changes. Once mandated, these modifications have the potential to negatively impact companies' long-term corporate health. Because creditors and lenders rely heavily on a company's financial reports to evaluate the corporation's financial health and borrowing capacity, business managers and accountants should prepare for potential changes impacting them. This essay will give a high level overview of the economy; then, the history and definition of corporate leasing will guide the reader to a focused discussion on lease accounting.

A Word on the Global Economy

The United States' and the global economies are powered by the growth in goods and services produced. Business investments, growth in stocks and values, investments, and trade are but a few of the factors influencing economic trends. The underpinning of economic growth is cash and investments. In the usual course of business, companies often lack readily available cash. Some will borrow funds or sell stocks; while for others, leasing provides a viable option to borrowing when growth is required. No matter the mechanism, to support their growth trajectory, corporations must add resources to meet or create supply. Growth companies, in particular, tend to be prone to poor operating performance (profitability), and are commonly limited in terms of available investment dollars. Leasing provides the opportunity for these companies to appreciate their business without impacting their balance sheet… at least for today.

Applications

Customarily, leasing allows companies the option of not having to make a hard investment. As evidence of its utility, leasing is now estimated to finance some $200 billion of equipment per year in the US. What are companies leasing? The following is a short list of examples:

• Aircraft
• Computer systems and software
• Trucks and construction equipment
• Office, medical equipment, and furniture
• Large manufacturing equipment and tools

Leasing offers financial benefits over purchasing, some of these include:

• Lower up-front cash requirements; a leased item can be acquired and used quickly.
• Limits the need for borrowed money; borrowed money limits available credit and ties up money which would produce a greater return if used in other ways.
• Provides the company to ability to maintain greater cash liquidity.
• Avoidance of owning equipment that becomes obsolete -- the lessor has the obligation to deal with getting rid of old technology.
• Known payment for which to budget; no depreciation to report.
• Leasing technology assets (depreciable) provides another source of credit.
• Advance lease payments, sometimes required, reduce future payments.

Types of Leasing

There are two main types of leases: Finance Leases and Operating Leases. The finance lease allows a company to finance the purchase of an asset, without ever acquiring the asset. The finance lease will give the lessee control over an asset for the majority of its useful life, imparting to the lessee the advantages and risks (maintenance, insurance, taxes) of ownership. The Operating Lease, which does not appear on the balance sheet, holds the owner / lessor responsible for the maintenance and upkeep. Some lease models are detailed below:

• A Lease Purchase provides the lessee an opportunity to buy the equipment at the end of the lease for a nominal fee, and become the owner who can then trade in or up. There is a fixed monthly payment, and because buyout terms are included in the original agreement, the value of the equipment is known at the end of the lease. The lease purchase allows the lessee, considered owner of the equipment, to depreciate the item. The leaseholder will record the equipment as an asset on the balance sheet and the monthly payments as liabilities.
• The Operating Lease, also known as the Fair Market Value (FMV) Lease is similar to Lease Purchase, but typically offers a buy-out at the end of lease, at a price that represents fair trade value of the equipment. The leaseholder also has the option of re-leasing or renting the equipment. The terms of this lease are usually 75% or less of the item's useful life, and the current value of the lease payments should not be greater than 90% of the FMV of the equipment -- using the lessee's established incremental borrowing costs. In contrast to the Lease Purchase, the payments on an operating lease are claimed as tax deductible operating expenses. In this case the lessor depreciates the value of the equipment, as the owner.
• Purchase upon Termination Leases (PUT), set an obligatory purchase price. A lease of this design offers a lower fixed lease payment during the term of the lease, and avoids an unknown lease-end risk for either party.
• A TRAC lease is used for "over the road" vehicles. A TRAC lease is a specific type of lease often used for costly vehicles like trucks, tractors and trailers. Residual values are predetermined but the payment deductibility benefit of a standard lease is maintained. Depreciation expense for the vehicle is recorded by the lessor (owner).

Attraction & Risk

Financial professionals have available to them a framework to make prudent decisions about the use and the determination of what terms create a capital or an operating lease. The Financial Accounting Standards Board (FASB) sets reporting standards and attempts to minimize misinterpretation of the regulations. Yet, some companies continue to practice financial engineering (modified interpretation), by which they take the liberty of recording a capital lease as an operating lease. Such practices carry markedly more risk to companies today than in years past, primarily as a result of 2002 legislation driven by the Securities and Exchange Commission (SEC) . Companies must use caution in interpreting the provisions defining qualifications for capital leases, as follows.

In 2002, the Sarbanes-Oxley Act, know as SOX or SARBOX for short, was the reaction by the legislature, to numerous corporate accounting scandals involving Enron, Tyco International, and other public corporations. The legislation established new or enhanced standards for U.S. publicly-owned companies as well as for public accounting firms. As relates to leasing of equipment and capital, Title IV of the SARBOX legislation applies. The nine sections of Title IV describe the formal reports mandatory for financial transactions which include off-balance sheet transactions, pro-forma figures and stock transactions of corporate officers. Because an operating lease obligation does not appear on the balance sheet, the company with such an arrangement will appear less leveraged upon analysis. For obvious reasons, this is a favorable arrangement for the reporting company. Stringent oversight of companies' accounting practices and punitive actions for blatant or even unintentional infractions should be forefront on the minds of companies and their management teams. For further clarification, see the following from the National Real Estate Investor.

"The operating lease structure is a form of off balance sheet accounting, which means the lease obligation is not reported as a liability on the balance sheet. Off-balance sheet accounting received new notoriety after the Enron implosion. Currently, accounting standards require a lease to be recorded as a capital lease if the arrangement meets any one of four classification tests established by FASB. As a result of the desirability of operating lease qualification, lease parties commonly structure leases in such a way to avoid capital lease accounting by a thin margin. Another metric of financial risk is the debt to EBIDTA (earnings before interest, taxes, depreciation, and amortization) ratio, which measures a company's leverage relative to operating cash flow. Nonetheless, a shift of operating leases to the balance sheet generally results in a significantly higher debt-to-EBIDTA ratio than a company would report under current accounting standards" (Davis, 2007, p.120).

Discourse

Implications to Maintaining the Status Quo

The Securities and Exchange Commission (SEC) holds accurate financial reporting at a premium and is suggesting more stringent regulatory directives by year 2009. The implications to public companies will be substantial; benefits to investors will include an increased transparency to public financials and more informed investment decision-making. As relates to leasing capital, for the lessees of the equipment, the accounting changes will surely increase debt levels and shrink actual earnings.

"The effect of capitalizing a lease is usually unfavorable. Assets go up yet debt goes up; leasing costs are eliminated but replaced by depreciation and imputed interest. Usually (not always) the sum of interest and depreciation exceeds the lease payment. Taxes are, generally speaking, unaffected. The Internal Revenue Service generally expects the lessee to deduct the lease payments, not the depreciation and interest. Under the FASB plan, which Herz calls 'a work in progress,' many companies will see their earnings drop. The ratio of debt to equity will go up. The return on assets will go down. At least the higher reported debt loads aren't likely to trigger a raft of credit downgrades from rating agencies like Standard & Poor's. S&P is already looking at footnotes and taking hidden obligations into account when assigning scores. Some might shrug all this talk off as a mere paper exercise. The disagreeable reality is that companies have been working the system to lower the amount of debt they show investors, even though lease debt is just as real as any bank loan" (MacDonald, 2007, ¶10).

Debt to Equity Ratio & a Company's Financial Standing

Financial managers know that long-term debt on their company's balance sheet reflects money the company owes and expects to pay off no sooner than 12 or more months. Examples of such long term debt include mortgages on corporate buildings or capital leasing arrangements. Companies with an overabundance of long term debt on the balance sheet find themselves besieged with interest payments and a risk of having too little working capital. Companies need to appear favorable to investors; one means by which they accomplish this is by displaying a favorable debt to equity ratio.

With new reporting regulations for leases looming, companies recognize their debt to equity ratio will increase, assumedly decreasing the amount of money their company can reasonably be able to borrow over long periods of time. The level of debt to equity displays how leveraged a company is; if the ratio is 40% or greater, this is seen as potential for liquidity problems.

From a 2007 spring issue of Accounting Today, Edward Nusbaum wrote, "Although there are legitimate tax and legal advantages to lease financing, too many transactions are structured for the purpose of arriving at a desired accounting treatment. The resulting balance sheet does not present a complete and transparent financial picture. Basic analytical tools like return on investment and debt-to-equity ratios are useless when neither the investment nor the debt is on the books. Before conducting even elementary financial statement reviews, users must look to the notes, and then make their own adjustments to published accounts based on what is, in many ways, incomplete information" (Nusbaum, 2007).

As referenced earlier in the essay, more stringent accountability is expected in the next 18-24 months. The inclination to misrepresent an operating lease on the balance sheet is understandable, yet caution in following the law is recommended. "Following publication of the proposed lease accounting standard, all leases will be deemed to be capital leases. This will move $1.25 trillion of undiscounted liabilities to lessees' balance sheets. Another major problem with {FAS 13} is that it requires three estimates to determine if a lease is an operating lease or a capital lease. As with any and all estimates, judgment errors as well as deliberate misconduct can enter the determination" (Burrowes & Sipple, 2007).

Added Complexity for Companies & Accountants

Property lease reporting will soon follow suit right alongside equipment and other capital leasing, and these changes will not be limited to the United States. The International Accounting Standards Board (IASB) is in lockstep with the FASB and its recommendations. A property lease, in its purest form, will be termed an operating lease as long as the terms meet all the criteria FASB designates. The challenge to companies is not insignificant as many large entities must lease space while undergoing construction, downsizing or expansion of existing facilities. In terms of total dollars reported in property operating leases, the amount currently recorded in this country is not insubstantial.

"Both the FASB and IASB [the bodies governing accounting standards in the U.S. and EU, respectively] are considering requiring all leases to be treated similarly to the way capital leases are today," said Chris Dubrowski, director of professional practice at Deloitte & Touche's national real estate practice. "Given that there's perhaps a trillion dollars' worth of operating leases out there -- and that's a conservative estimate -- it will be a major change." In an operating lease, the landlord transfers only the right to use the property to the tenant. At the end of the lease the tenant returns the property to the landlord. Since the tenant assumes no risk of ownership, the company treats the rent as an operating expense in its income statement, effectively keeping it off the balance sheet. In a capital lease, the tenant assumes some of the risks and benefits of ownership recognizes the lease as an asset and the rent as a liability on its balance sheet and gets to claim depreciation on the asset and deduct the interest expense component of its rent payments. Tenants will have to record the present value of remaining lease payments as a liability on their books if the operating leasing concept dies, Dubrowski says. "Tenants won't like this, because if they lease thousands of locations, such as a major retail tenant might, they'll have all kinds of debt on their books that they didn't before." He speculates that the practical effect of losing operating leases could be that tenants push for shorter-term leases since a two-year lease say, will be less of a liability than a five-year lease under the capital lease model. As for landlords, the change would be a little more complicated. Landlords would no longer record rental income, but rather the payment of principle and interest from the "receivable" (that is, the lease). "The landlord will recognize interest income instead of rental income," said Dubrowski. "That's simple if you only have a few tenants, but not so simple if you have thousands." Despite the prospect of increased accounting complexity, however, Dubrowski expects that the real estate industry will not stagger under the weight of change" (SCT Week, 2007).

Case Study: The Impact of Changes in Property Lease Reporting

Should accounting reporting changes occur as planned (operating leases becoming capital leases) by the FASB, the following major retailers would face unfavorable earnings-before-taxes and debt-to-equity ratio changes.

[] For calendar year 2006.

Source: Charles Mulford, Georgia Institute of Technology.

Case Study: Walgreens

"Walgreen's liabilities would more than quintuple if the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board adopt a requirement that companies include lease obligations on their balance sheets, according to a recent study. With 5,675 leased stores across the country, Walgreen would face a more than 400% surge in liabilities, the second-biggest jump among 50 companies included in a study commissioned by Chicago-based accounting firm, Grant Thornton LLP.

Still, investors note that the change wouldn't affect the company's strong earnings and cash flow. And Walgreen's credit rating would be minimally affected despite the surge in liabilities. 'With the significant store count that they have, it's not an inconsequential number, but we have already factored that in our thinking. And I don't think it will affect the company in the marketplace,' says Greg Pusinelli, principal at Chicago-based William Blair & Co. LLC, which held 7.3 million Walgreen shares as of Dec. 31.

Any change is at least two years away, an FASB spokesman says. A Walgreen spokesman says the company isn't fighting the proposal and will abide by any rule adopted.

Under current rules, most Walgreen store leases qualify as 'operating leases' which don't have to be recorded as liabilities. Instead, the company reports rent payments as expenses on its income statement and discloses lease obligations in footnotes to its financial statements.

In the Grant Thornton study, Walgreen ranked behind Austin, Texas-based Whole Foods Market Inc., which would see liabilities jump 666% under the proposed rule. Walgreen's would surge 421% from 2005 levels to $20.3 billion. Its debt-to-equity ratio would more than triple to 229%. Assets would rise 165% to $29.2 billion, knocking its return on assets down to 5.3% from 10.7%. Rival drug chain CVS Caremark Corp. would see similar changes to its balance sheet.

'If anything, the rule change is going to increase transparency,' says Matt Magilke, an assistant professor of accounting at the University of Utah and author of the study. 'It's going to help investors make better decisions'" (Fields-White, 2007).

Considerations in Mitigating Risk & an Opportunity for Entrepreneurs

"Corporate reporting at many organizations ran aground in improper lease accounting in 2005, causing more than 200 companies to restate their financial results. In some cases, these businesses failed to follow well-established accounting rules, including FAS-13, Accounting for Leases, which dates back to 1976. Lease management technologies can help businesses avoid this reporting pitfall. Joseph Pucciarelli, research director for pricing and leasing evaluation services, a market intelligence and advisory services provider, IDC, notes that demand for his software is on the upswing. 'Through 2009, IDC expects at least one third of large multisite, multinational companies to revise and revamp their lease management processes with a combination of process and tool initiatives, he reports' " (Business Finance, 2006).

Conclusion

Financial managers are not solely responsible for public companies' financial reporting, but they do hold primary accountability. These professionals work in tandem with their accounting and audit firms; responsibility to the SARBOX and FASB legislation mandates apply to both. Not surprisingly, given the ever-increasing complexities surrounding these issues, some are looking to outsource their lease management, as highlighted earlier in this text. The cost to invest in what might turn out to be an "insurance policy" against financial misadventure might be far less than punitive actions taken for SARBOX infractions. Fortunately, a modest lead time is available before the formal lease directives are instituted. Prudent financial managers will take heed and proactively prepare company owners and their accounting firms to approach the changes ahead of deadlines. It is contingent upon managers to uphold their duty to practice legal, ethical and fiscally prudent management of their company's resources.

Terms & Concepts

Balance Sheet: Snapshot of a company's assets, liabilities, and owners' equity at a specified time, commonly at the end of an operating period such as one year.

Capitalization: The accounting term describing the inclusion of costs to acquire an asset into the price of the asset.

Debt to Equity Ratio: Financial ratio calculated by dividing debt by owners' equity. Debt to equity ratio reveals the proportion of debt and equity a company is using to finance its business.

Depreciation: The periodic, scheduled write-off (expensing) of a capital asset over the asset's useful business life. This allows a business to claim a deduction for an asset unlike those eligible to be deducted in just one year.

FASB (Financial Accounting Standards Board): The organization that establishes financial accounting and reporting standards. FASB standards control the formation of financial reports and are sanctioned by the Securities and Exchange Commission.

FAS 13: FASB Standard 13 which establishes standards for reporting of leasing for both lessors and lessees.

Leasing: Rental of industrial equipment and investment goods-for example, machinery, technical equipment, vehicles, real estate.

Lessee: Someone who uses a leased property under a lease.

Lessor: It depends on the type of lease, but the lessor is either the owner of leased equipment or property being leased, or the owner of a security interest in the property being leased.

Liabilities: Monies owed by a company to an organization or an individual. Liabilities must be paid on or before a specified date, usually owed to a company's supplies and/or creditors.

Liquidity: Describes the ability to convert an asset to cash quickly.

Long-term Liabilities: Monies owned by a company that are expected to be paid no sooner than 12 months.

Sarbanes-Oxley: 2002 Federal legislation that created new standards for all U.S. public company boards, management, and public accounting firms including formal financial reporting standards.

Securities and Exchange Commission (SEC): The Federal agency responsible for supervision and regulation of the securities industry.

Securities: The name for {financial} shares and bonds of all types.

Bibliography

Bruche, M. (2011). Creditor Coordination, Liquidation Timing, and Debt Valuation. Journal Of Financial & Quantitative Analysis, 46(5), 1407-1436. Retrieved November 24, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=67547634&site=ehost-live

Burrowes, A., & Sipple, S. (2007). SEC targets Penthouse, Comverse Tech. Chartered Accountants Journal, 86(6), 70-71. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25907569&site=ehost-live

Web-based lease management. (2006). Business Finance, 12(1), 54-55. Retrieved October 17, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=209 60077&site=ehost-live

Davis, T. (2007). Leasing changes afoot. National Real Estate Investor, 49(5), 120-120. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25040135&site=ehost-live

Fields-White, M. (2007). Balance sheet change possible for Walgreen. Crain's Chicago Business, 30(17), 2-2.

Jianzhou, Z., & Ye, Y. (2013). Why do profitable firms use less debt?. International Journal of Business, Accounting, & Finance, 7(1), 140-151. Retrieved November 24, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87722207&site=ehost-live

MacDonald, E. (2007). Debt hazards ahead. Forbes, 179(13), 80-81. Retrieved October 17, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25273490&site=ehost-live

Mallick, S., & Yang, Y. (2011). Sources of financing, profitability and productivity: First evidence from matched firms. Financial Markets, Institutions & Instruments, 20(5), 221-252. Retrieved November 24, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=67196324&site=ehost-live

Nusbaum, E. (2007). Lease accounting rules need to be changed. Accounting Today, 6, 8. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24524741&site=ehost-live

Operating leases could be thing of the past. (2007). SCT Week, 12(30), 1. Retrieved October 17, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26003569&site=ehost-live

Suggested Reading

Companies warned on leases. (2006). Accountancy, 137(1352), 81. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=20544601&site=ehost-live

Leveraged lease transaction income, income tax uncertainty. (2006). Practical Accountant, 39(9), 18. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22232164&site=ehost-live

Operating lease stepped increases. (2006). Accountancy, 137(1354), 86-87. Retrieved October 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21324843&site=ehost-live