RSS feedsThe thorny question of how companies should be made to account for substantial leases has had the setters of accounting standards scratching their heads all over the developed world. Dear old SSAP 21 made light of the issue by recognising a fundamental distinction between financial leases, which should be on the balance sheet, and operating leases, which could be treated as an expense.
However, this position left enough room to drive a coach and horses through the standard and all kinds of weighty and substantive items, from IT equipment to hefty plant, became largely invisible to readers of accounts.
The logic that distinguished between whether a lease was a financial lease or an operating lease came down to the extent to which the lessee or the lessor held the substantive ownership rights and risks.
This state of affairs does not please standards setters. The Accounting Standards Board and other standard setters regard existing leasing standards as deficient because they omit material assets and liabilities arising from operating lease contracts. Nor are they thrilled with the vagueness that allows minor differences in contract terminology to allow one lease to be treated one way and another, to all intents and purposes similar, lease to be treated differently.
What the standard setters want, and are currently mulling over, is a standard that would treat all substantive leases, operating and financial, as on-balance sheet items. The ASB, for example, points out that it is commonplace for investment analysts and credit rating agencies to recast financial statements by calculating the assets and liabilities implicit in off-balance sheet operating leases.
However, financial directors of all hues would far rather not clutter up their balance sheets with amounts they have long been accustomed to think of as simply normal running expenses.
In practice, as Jonathan Andrew, CEO of Siemens Financial Services explains, lenders are more than willing to arrange IT deals with corporates that are cast in such a way as to leave some risk with the lender. As things currently stand, this means that a large corporate could sign up with Siemens for a substantial IT contract, in excess of £20m, say, and Andrew would be very confident that the deal could be drafted off-balance sheet, as an operating lease, and win the blessing of the corporate’s auditors.
If £20m sounds too high for an IT infrastructure deal, remember that the deal can also include a refresh of the company’s desktop assets (PCs, printers, notebooks, mobile devices, etc) and its network infrastructure as well as all its storage and servers.
“The big distinction for us, apart from who owns the risk, is that a financial lease or an on-balance sheet lease involves long-term assets,” says Andrew. “This we take to mean assets held for seven years or more. Most IT assets are obviously short-term leases, held for three to five years at most, and this makes them very suitable for off-balance sheet treatment.”
A second feature that makes it sensible to treat these large IT leasing deals as off-balance sheet items, he says, is that they can wrap a significant degree of service and consultancy in with the hardware. The corporate can anticipate its service and consultancy requirements through the lease and add it to the hardware to generate the total lease amount. This again makes it more of an expense item, since the service is paid for as part of the set monthly payment.
The third and critical factor, to get auditor buy-in to the deal being off-balance sheet, Andrew says, is that there should be a significant residual value to the equipment. This “residual risk” remains with Siemens, which has developed a great deal of expertise in the second-hand IT hardware market to enable it to shift end-of-lease kit.
“The new Finance Act, which comes into force in April is going to have an impact here,” says Andrew. “At present, its stance is to look at longer-term infrastructure transactions; it will be treating them as loan products and bringing the UK treatment into line with IAS and with US GAAP. But we believe that its impact on IT leasing will be minimal since, as I have said, this kind of lease is not long term.”
The key to a substantial off-balance sheet IT leasing deal is to have a lender that is willing to sign up for the asset risk. The corporate then has to ask itself if it really wants to own the asset. If the answer is yes, Andrew says, then the deal will have to be a financial lease, and the whole transaction will have to be on-balance sheet.
The answer, in fact, should probably always be no, he says, because there is no particular virtue in a corporate owning such assets. Ownership in this instance simply means being stuck with the residual risk – but what does the average company know about the second-hand computer market?
There is a very precise analogy here with vehicle fleet leasing. In both contexts, the essence of the deal is the leasing company’s ability to price the residual risk in a way that allows it to offer an attractive price to the client without getting bitten three years later by discovering that it has “bought the business” by dramatically overestimating the residual value of the vehicle fleet.
Finally, if the lender is also prepared to price into the deal the ability of the lessee to switch out and put in new assets at pre-agreed stages in the contract, the deal should definitely be “off-balance sheetable”, Andrew says.
“On a discounted cash flow these deals will be structured so as to be at under 90% of the overall cost of the transaction,” he adds. “We call this the 90/10 test. You take the net present value of the rental scheme, discounted at a commercial rate of interest, and if the net present value is less than 90% of the overall value, then effectively, from a pure financial test, someone is taking a risk that is significant in the contract. And that someone is the funder.”
Part of the problem for lenders doing these deals is that it is impossible to structure the deal in a way that absolves the lender, as the ultimate owner of the kit, from performance risk. If the kit turns out to be demonstrably unfit for purpose (and, let’s face it, many IT projects fall under that heading), then the lender is going to be in a peculiar position if the corporate decides to cease payment and walk away from the deal. (“I’m contracting for X services a month. You are not performing. Goodbye. You, the lender, are now the proud owner of 2,000 desktop computers, 200 printers, 1,600 notebooks, 75 servers, etc, etc.”)
For this reason Siemens will only do offbalance sheet IT deals where the IT provider is a blue chip company such as IBM or HP. “We will always look to structure these deals in such a way that the claim for non-performance falls back on the service or equipment provider, where it should lie,” Andrew says.
This approach has stood Siemens Financial Services in good stead in its relationship with enterprise software supplier SAP. “SAP doesn’t want to get into being a bank but it does want to provide enterprise-grade applications and services to clients as a global contract, and allow companies to acquire these services as a lease arrangement. So we do the global deal for them,” Andrew says.
From a funder’s point of view, being able to structure deals as off-balance sheet for corporates is a very important way of the funder adding value to the contract. “Providing funding for big-ticket items is a very competitive, commoditised market. So the way to add value to it is to come up with creative structures that will allow the customer to get what they want, and will generate a reasonable return for us,” Andrew says.
Andrew points out that getting a deal offbalance sheet is not a matter of contriving risk. “It is not a purely financial algorithm,” he says. “There are plenty of operating leases that have been disallowed because they fail the ‘substance over form’ test. There must be a real risk of the risk materialising.
“Auditors are very wise now to ploys in this area and that is a good thing. It differentiates between real off-balance sheet transactions and the pure financiers who want their deals to look off-balance sheet without them actually taking any risk.”
Siemens always engages the auditors of both the supplier and the client to ensure that they participate fully in the thinking behind the deal. Andrew is convinced that these deals will continue to hold water, whatever the accounting standards setters come up with by way of a new leasing standard.
Peter Ttofis, FD of the UK arm of the £10bn turnover printer and copier giant Ricoh, says that deals done by his company for big corporates are around the £500,000 mark and normally have a structure that makes them off-balance sheet. “Once the deal is done, we sell it to a leasing company like Siemens so we get our money upfront,” he says. “We build consent to assign into the contract and Siemens appoints us as its billing and service agent. This is where we get the service element of our contract.”
Ttofis greatly prefers an off-balance sheet arrangement wherever large sums are involved. “As an FD I am always happier with off-balance sheet deals. When you start looking at returns on assets employed, it makes your ratios look a lot better to have things off-balance sheet, and the better your ratios, the happier your shareholders,” he says.
So what’s Ttofis’s view of the controversy over accounting for leases? “A bit of a storm in a teacup,” he says. “If you want to see what I am expensing, look at the headline figure. It’s all there.”
