In May 2013, the Financial Accounting Standards Board and International Accounting Standards Board issued a revised exposure draft outlining proposed changes to accounting for leases. According to a joint news release from the Boards, the proposal “aims to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations and the risks to which it is exposed from entering into leasing transactions.”
Lou Manitzas, Team Leader of OneWorld Business Finance, discusses the proposed changes, their significance and how business owners should respond to the changes.
Q: Why should these proposed changes be of interest to businesses?
Lou Manitzas: Quite simply, the accounting rules are going to change. What was formally off-balance sheet financing is going to become on-balance sheet. That’s the main thrust of it.
This relates to equipment financing, real estate leases and office space, and it can also relate to other types of intangible or project-type financing that has usually been done off-balance sheet.
Off-balance is typically debt that shows up only in your footnotes or in an appendix/addendum to your financial statements. On-balance sheet means the asset and the corresponding liability appear in the financial statements and would impact all of the financial ratios or covenants.
Q: Why would this change be so significant?
LM: Historically, when an asset or debt is off-balance sheet, it just shows up as an expense. There is no liability and there is no interest cost. It would be expensed for the full payment on the income statement when it’s off-balance sheet.
When the changes are enacted — and it is a matter of when, not if at this point — you would have interest expense and a loan combined with an asset and depreciation or depletion.
The big distinction is that one is a reduction from net income and the other is a partial reduction from net income for the interest expense, but it’s an asset that is then also depreciated or depleted, depending on what type of asset it is on the balance sheet.
Q: What will be the impact of the change of going from off-balance sheet financing to on-balance sheet financing?
LM: The impact of the change is that it will add debt on your balance sheet once you have these assets and debt on-balance sheet, and this can really impact your financial ratios. Leases off-balance sheet may have impacted income but this would affect both income to a lesser extent (with interest expense) and your financial ratios to a greater extent.
When the change is enacted, many companies may see their financial ratios get worse overnight. This could potentially have a big impact depending on how much off-balance sheet financing companies have been doing. It will be a really significant impact for some companies. What it’s going to probably cause is short- and long-term interest rates to rise and credit ratings to go down while the impact of the transition is being absorbed and understood by the market.
At this point in time, the full impact of the change is unknown because the full impact of how much companies have off-balance sheet is unknown. For example, when digging into a bankruptcy like Detroit’s, people are learning that the city may have had more off-balance sheet debt than on-balance sheet. One report had the numbers at $9.20 billion in off-balance sheet debt and $8.78 billion in on-balance sheet debt. There’s a lot of money the city owes that wasn’t being included in its financial statements or understood by bondholders.
Q: Why is this change coming about now?
LM: The practice of off-balance sheet financing has been done for years, but what I really think brought attention to it — and ultimately brought about the need for a change concerning it — was Enron. Enron did a significant amount of off-balance sheet financing. That’s what its leadership was a master of: creating deals where the company had no debt and all of the equity — the cash and income — on its balance sheet when in reality it had billions of dollars in debt off-balance sheet that the company owed, so its financials were essentially falsely represented.
Q: How should a company assess its on- and off-balance sheet financing situation?
LM: I think companies need to be proactive. It is critical to work with your accountants and auditors to understand your exposure, how much you have off-balance sheet and what your pro forma financial statement is going to look like when these new rules are enacted.
Companies should really look at projections of what they would look like if you took all of their off-balance sheet debt and put it on-balance sheet. How would your financials look? How would your ratios look? Will the change automatically bust all of your debt and financial covenants? If so, you might have to redo all of your financial obligations and financial borrowings. It’s better to start making some changes now.
It could be very important for companies with a lot of exposure. Almost all companies I see have rental expenses for offices or equipment that have been traditionally off-balance sheet. This may now become on-balance sheet.
Q: What else should a company do now to prepare for the rule changes?
LM: The best practice would be to go out and get longer-term relationships for lines of credit and lock in fixed rates in areas such as equipment financing for as long as you can. You will do much better to lock in today’s rates as they’re only going to go up leading up to and after the changes are enacted.
I would be careful to negotiate financial ratios and covenants that are restrictive and don’t include some kind of adjustment factor for this change. As companies close on new borrowing, lenders may try to give themselves a way out if this change is approved. In other words, when it happens, the lender can now take the ratio from 5:1 debt-to-equity to 10:1 because the borrower will have all of its off-balance sheet debt changing to on-balance sheet.
It’s important to take all of this into consideration now. Discuss the changes with your lenders, and assess how they are willing to work with you as the changes loom on the horizon — and get it all in writing. You’re not going to want to wait until the changes take effect and then try to change relationships. This will only make matters worse, especially because other borrowers will be attempting to make the same changes all at the same time.
Lou Manitzas (email@example.com) is President and CEO of OneSource Financial Corp., and active in the strategic functions of the sales operation and the management contracts for OneWorld Leasing, Inc. and OneWorld Business Finance, LLC. His primary focus is growing these existing businesses as well as researching and further developing new business segments to serve the financial needs of each company and its prospective clients.