IT Finance: Absent Trends

The 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.”