New lease accounting rules could create pension funding gap

IF you start from the premise that accounts should be “true and fair”, which is to say that they should present a reasonably accurate view of a company’s financial position, then anything off-balance sheet becomes suspect. Operating leases were always off-balance sheet until the IASB finally got its lease accounting standard past the finishing line, and now they’re not. So what is the impact likely to be?

The Wall Street Journal ran a story quoting IASB chairman Hans Hoogervorst on the new standard. He said, not surprisingly, that it would provide much-needed transparency on companies’ lease assets and liabilities. “(Henceforth) off-balance sheet lease financing is no longer lurking in the shadows,” he said. However, according to the IASB’s own reckoning, the new standard, along with a parallel standard introduced by FASB for US companies, will add $3tn (£2.07tn) to corporate balance sheets around the world. That is not a small number.

Richard Farr, managing director of Lincoln Pensions, and a former partner at BDO and PwC, has been following the glacial progress of the IASB’s epic struggle to get its leasing standard to the finishing line for many years. He argues that the standard could not have been completed and unleashed upon global companies at a worse time.

“What we are looking at, now that the IASB and FASB have finalised their respective leasing standards, is nothing short of the perfect storm for corporate reporting,” he says. “We have off-balance sheet leases being brought on-balance sheet through some very questionable and subjective decisions about what constitutes the value of the supposed ‘asset’, at the same time as companies are dealing with massive deficits in their defined benefit (DB) pension schemes.

“Moreover, all this is happening at a time when the global market is looking decidedly wobbly. This is likely to have an extremely negative impact on many companies’ relationship with their banks and with funders, and is very likely to have a severe impact on corporate credit ratings,” he predicts.

Holiday firms under pressure
The worst-hit sectors will be the retail sector and hotel and airline companies that have traditionally leased property and aircraft for long periods on operating leases. Before the new regulations were announced on 13 January, there was no requirement to report these leases as part of the company’s assets and liabilities. They were disclosed in a note in the accounts.

“In these sectors future payments of off-balance sheet leases equates to almost 30% of total assets, according to the IASB’s own figures,” Farr says. He points out that those in favour of the new standard take the view that there is no problem because the new on-balance sheet treatment of operating leases recognises the leased asset as an asset of the company, thus balancing out the liability that comes onto the books. However, Farr points out that while the liability stays on the book in full, year after year, the asset value is written down through depreciation.

The net result for any company that finds itself running into cash flow difficulties is that you end up with a large and growing discrepancy between the value of the asset and the value of the liabilities.

“You create a massive funding gap in the accounts which exacerbates the problems of any company that is starting to run into trouble. The new treatment will make the balance sheet look far worse than it would have before the new standard came into effect,” he argues.

Tesco hit
The negative impact the standard will have can be seen instantly from the impact on Tesco’s accounts, Farr adds.

“Tesco’s liabilities go from £8.6bn to £17.6bn at a stroke,” he notes. This figure comes from analysis carried out by the Bernstein analyst, Richard Clark, whose work Farr cites.

More importantly, if the company is running into trouble, it is self evident that in reality the asset on its books would fetch far less than the reported price since assets sold when a company is in distress are heavily discounted. Readers of accounts know this so will tend to view whatever funding gap exists as being understated rather than overstated.

“Add in the extreme volatility in global markets over the last nine months or so, caused by the falling price of oil, along with the massive deficits in pension schemes and the deepening slowdown in China, and you have a real problem,” says Farr. “It is a travesty that this standard has taken so many years to finalise since it has allowed the operating lease issue to build and build, to the point where we are now looking at this $3tn figure.

“How many banking covenants will require adjusting when bankers get to grips with the next set of reports and accounts from their major corporate clients? How does the new standard impact corporate going concern provisions? These are serious questions that will have to be answered in the year ahead.”