Accounting Rules Could Affect Your Rental Operations - Balance Sheet
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SECTION: Balance Sheet

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Accounting Rules Could Affect Your Rental Operations

By Scott Stafford, BDO Seidman

Article Date: 02-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.

Familiarize yourself with the international accounting standards as they apply to operating leases, and what that could mean to your rent-to-rent strategy.

There are many instances where the world of accounting policy interacts directly with the operations of companies. One only has to look at the current U.S. credit market meltdown and the related accusations, founded or unfounded as they may be, to see that the concept of fair-value accounting distorted the balance sheets of many financial institutions, which led to increased public distrust and contributed to the collapse of some well known institutions.

The equipment distribution industry is perhaps more closely linked to the realm of financial accounting and taxation policy than any other. This is largely due to the influence that lease accounting treatments or available depreciation method options have on a company’s decision to purchase or lease needed equipment. The past is filled with examples that support this thought, including these specific examples:

  • The Economic Recovery and Tax Act of 1981 – Established the Accelerated Cost Recovery System of tax basis depreciation, which spurred equipment sales due to the accelerated tax depreciation deduction afforded to companies depreciating purchased equipment under this method.
  • Statement of Financial Accounting Standard No. 13: Accounting for Leases (SFAS No. 13) – Enacted in 1976, it is the current U.S. lease accounting standard that drove increases in rent-to-rent business due to the “operating lease” concept that allows companies to lease equipment without recording the asset or obligation on their balance sheet.
These are two examples of the many that could be cited. From this long list, however, perhaps no other policy has affected the industry more than SFAS No. 13. The off balance sheet treatment of operating leases and the well defined bright line test of determining lease classification set forth in this standard created incentive for companies to lease needed equipment. This led to an explosion of equipment leasing activity over prior decades, as well as an explosion in the number of equipment distributors incorporating rent-to-rent strategies into their business models that has largely continued to this day.

When we switch our view from the past relationship between accounting policy and the equipment industry toward the future, the words of the great baseball manager Yogi Berra come to mind: “The future is not what it used to be.”

Since 2002, the Financial Accounting Standard Board (the governing body of U.S. accounting standards) has been in discussions with the International Accounting Standards Board (IASB) to chart the way toward converging U.S. accounting standards and the International Financial Reporting Standards (IFRS) issued by the IASB.

So what does this mean? Simply put, there is a movement to have one internationally accepted set of accounting standards. In the global view, the U.S. is coming to the party slightly late as more than 100 countries (including Australia and the United Kingdom) already use IFRS, with other major countries such as India, Chile, Brazil, and Canada coming on board within the next two years.

It appears that the future, indeed, is going to be different than what it used to be, although it is not uncommon in the realm of accounting standards to hear many years of talk about potential change, ultimately resulting in no change at all. With that said, would the U.S. actually make such a drastic change to the accounting standards that we have so meticulously developed over the decades? In other words, should we really be worried that this will happen?

For several reasons, the consensus answer is yes, with a primary reason being that the Securities and Exchange Commission (SEC) has heavy influence on the direction of U.S. accounting standards, and the SEC is supportive of making the change to IFRS. In the SEC’s view, adoption of IFRS would increase the comparability of U.S. company financial statements to those of their international competitors that report their financials using IFRS. In the global economy in which we now live, they see this as a positive for U.S. public companies. The global economic slowdown we are now living through further highlights the view that we do operate in a true global economy and furthers the momentum within the SEC to shift the U.S. to IFRS.

In November of last year, the SEC proposed a roadmap for U.S. public companies to convert to IFRS. Under this roadmap, the SEC would allow U.S. public companies to voluntarily adopt IFRS as early as fiscal years beginning after Dec. 15, 2009, and it would require adoption in either 2014 or in a phased-in approach from 2014 to 2016, depending on the size of the company. This proposed timeline has not been adopted, to date, and is still open for public comment through Feb. 19 of this year. Even so, the proposal provides us with the SEC’s view of when IFRS should be adopted in the U.S. It is uncertain at this point when the FASB may require nonpublic companies to adopt IFRS, but the FASB and SEC have historically worked together closely, suggesting that the FASB’s timeline could be similar.

Therefore, the writing appears to be on the wall that the wave of conversion to IFRS is coming to U.S. shores. So what does this mean to the equipment distribution industry, and, more specifically, what does this mean for one of the key U.S. accounting standards currently influencing the industry, SFAS No. 13?
To answer that question, one must first take a general look at the conceptual framework of IFRS and then look at the current IFRS standard addressing leasing transactions. At its core, IFRS is a principles-driven set of standards. This differs from current U.S. accounting standards that are much more proscriptive or rules-based in nature. For example, currently, in many instances U.S. accounting standards provide “bright-line” tests to apply in making an accounting judgment. However, under IFRS there are far fewer of these bright line tests and far more reliance on determining in principle what the transaction represents and letting that dictate the accounting treatment.

Consistent with these thoughts, IFRS does not have the familiar SFAS No. 13 proscribed bright line test for evaluating whether a lease is an operating lease:
a. Does ownership transfer at the end of the lease?
b. Does the lease contain a bargain purchase option?
c. Is the lease term greater than 75 percent of the estimated economic life of the asset?
d. Does the present value of the minimum lease payments exceed 90 percent of the lease inception fair value of the equipment?

Under the principles-based IFRS, these concepts are retained but they do not carry the stand-alone decision making or bright line test weight they are afforded under SFAS No. 13. Instead, the analysis of whether a lease is treated as an operating lease hinges on whether the overall substance of the transaction substantially transfers the risks and rewards of ownership to the lessee, and these concepts are simply items to consider in that evaluation.

What this means is that companies and their auditors are going to be exercising greater judgment in classifying a lease under IFRS, and since the more conservative approach is to classify a lease as capital and put the assets and liabilities on the balance sheet, the likely outcome will be that fewer leases are afforded operating-lease classification and the off-balance-sheet treatment those leases enjoy.

As an example, let’s say that during a lease classification evaluation the present value of the minimum lease payments is 89 percent of the present value of the equipment. Provided none of the other criteria are met, this lease would be afforded operating lease classification under SFAS No. 13. However, under IFRS it is highly unlikely that a 1 percent difference in that measurement would change the classification of the lease, and as a result the lease would be deemed a capital lease (or as IFRS refers to them, a “finance lease”).

Since the assets – and more importantly, the liabilities associated with a capital lease – are required to be recorded on the balance sheet of the lessee, and given the prevalence of working capital ratio and debt-to-equity ratio financial covenants in the U.S. debt markets, it does not take too much imagination to envision the impact that these changes could have on the typical U.S. rent-to-rent equipment business model. The good news is that the historical cost of leasing versus purchasing analysis factors such as discounted cash flows, depreciation expense, and maintenance expenses would still be applicable.
The additional good news is that you are now aware of the potential change and can take this knowledge into your next long-term business strategy meeting.

Beyond the convergence of U.S. accounting standards with IFRS, a few other threats loom over the long-term future of the operating lease concept’s impact on the rent-to-rent market. These include increasing pressure for transparency in financial statements and elimination of off-balance-sheet transactions in a post-Enron world, as well as the concept of fair-value accounting that is slowly migrating beyond the valuation of financial instruments.

By no means would even the outright death of the operating lease bring an end to the rent-to-rent strategy; however, it would be wise when envisioning the future operating environment of your company to consider the potential impact that its absence could have – because its prevalence does appear to be coming to an end.

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