Published in Asset Finance Europe, November 2009
For decades, the accounting rules (SSAP21, then IAS17) have classified lease as either finance leases or operating leases (contract hire). Finance leases were like loans; the hirer was committed to pay back the lessor’s total investment. Operating leases were like long term rentals; the lessor kept the residual value risk and needed to sell the asset to recover its investment in full. So finance leases were shown as liabilities on lessees’ balance sheet whereas operating leases were accounted for ‘off balance sheet’; the lease payments being expensed in the profit and loss account and the future rental liability shown as a note to the accounts.
Investment analysts have never much liked these classifications. They have always felt that a company’s obligation to make future payments – of any kind – should be shown on its balance sheet.
The International Accounting Standards Board (IASB) is reviewing the lease accounting rules and believes all leases should be ‘on balance sheet’, the ‘asset’ being the lessee’s right to use the leased items for the lease period. The asset value would be calculated by discounting the future lease payments (and other outgoings the lessee was likely to incur, such as extension rentals, damage recharge costs and excess mileage costs) to present value, using the lessee’s incremental borrowing rate. The asset would be depreciated over the lease period (including any likely extension period) or, if shorter, the economic life of the asset.
The balance sheet would show the liability to make any future payments, similarly discounted and probability-weighted.
If you see the opportunity for some subjectivity to appear in these calculations, I think you may be right. I expect lessors would assist their clients with these calculations. Hopefully short term hire will be excluded from these arrangements.
Unless the IASB has a radical change of heart the detailed rules for this new approach will be published in June 2010 and the new standard – accounting law – will go live by June 2011. Many vehicles on lease now will still be on companies’ fleets by then.
Whilst waiting for these changes to come along we have been presented with a new international accounting standard for small and medium sized enterprises, IFRS for SMEs. It was released in July 2009 and, basically, said that all the old rules still apply, that operating leasing remains off balance sheet and does not mention at all the possibility that this might change. SMEs make up 95% of all businesses and this new IFRS should therefore be good news to those SMEs that like the off balance sheet nature of operating leases. But it’s not all good news: Once the IASB’s lease accounting project has been finalised and we have a new accounting standard, they will look again at the IFRS for SMEs and decide whether it needs to be updated.
So, if the IASB project results in operating leases being put on lessees’ balance sheets, would this significantly affect the attractiveness of contract hire – a type of operating lease? I even heard at one pundit say this might mark the end of contract hire!
To answer this question we have to look at why businesses take cars on contract hire in the first place.
Contract hire has many advantages. The lessor sources, buys and delivers the vehicle, supplies annual tax discs and collects the vehicle at the end of the lease. They pay for servicing, maintenance and repairs (SMR), take the residual value and SMR risks, and pass on the benefit of their buying power. The lessee just pays the rentals and sorts out the insurance, and so long as the vehicle is kept in reasonable condition and the contracted mileage is not exceeded, there is nothing else to pay.
Contract hire is a beautifully elegant product it is no surprise it has become supremely popular. There are some tax benefits, just for good measure, and of course it also keeps the client’s bank overdraft free to meet working capital needs. Oh yes, and it also allows the lease to be kept off the lessee’s balance sheet.
Every fleet is different and every business will have its own reasons for choosing contract hire over other products. For some, the key benefit is that the lessor bears the residual value and SMR cost risks. Some like the tax benefits, the overall cost savings or the extra line of credit. Others cite the big saving in administration compared to managing the fleet in-house. Contract hire is a fine example of outsourcing.
In thirty years of talking to businesses about leasing and fleet management I must have spoken to hundreds of businesses about their fleets. Few had chosen contract hire primarily because of its balance sheet treatment, and they were all quoted companies with large fleets who said contract hire helped keep their Return on Asset ratios high. In truth, however, market analysts have been simply going to the notes to the accounts, finding the information about operating leases and using these numbers to recalculate this ratio.
So if these new accounting rules are introduced, will some companies stop using contract hire? Yes, but they will be few and far between (though some might be quite big).
And will this mark “the end of contract hire”? Absolutely, definitely, positively not!
Professor Colin Tourick