OREANDA-NEWS. New accounting rules that will require companies to include virtually all leases on their balance sheets will not affect credit ratings or the approach Fitch Ratings uses in adjusting leverage metrics to take account of leases.

ASC 842, released by the Financial Accounting Standards Board (FASB) on 25 February, and IFRS 16, released by the International Accounting Standards Board (IASB) in January, could reduce the attractiveness of leasing for some corporates, leading to increased direct ownership of assets. But the accounting treatment would be only one factor to consider.

In our analysis of operating leases, we capitalise the annual charge using a multiple to create a debt equivalent. This represents the estimated funding level for a hypothetical purchase of the leased asset. The new accounting rules for leases take a different approach, requiring companies to include the net present value of all future lease payments.

The new approach reflects companies' legal commitment under their leases, but we believe ours is a better reflection of the economic reality of these transactions. When the asset being leased is fundamental to the continued operation of a company, we generally expect that company to use it for its full economic life. The multiple replicates the debt needed to fund the asset over that lifetime and therefore acknowledges the likely renewal of the lease. The contractual minimum approach does not necessarily capture the permanent nature of these assets, especially for regularly renewed short-term leases. We therefore expect to continue adjusting companies' reported figures to create a debt equivalent.

The 8x multiple we often use can be adapted to reflect the nature of the leased assets. We apply lower multiples for assets with a shorter economic life and, mostly in emerging markets, to reflect sharply different interest-rate environments in the countries concerned. We also may not capitalise operating leases where we see them more as an operating cost than a payment under a longer-term funding structure.

The main difference between the IASB and FASB standards will be seen in the income statement.

The IASB will require companies to recognise separate amortisation and finance costs on leases. The FASB will require this for capital/finance leases, but most operating leases will be able to continue recognising a single total lease expense. Separating finance and amortisation costs may result in higher reported charges in the early years of a lease, depending on the term of the lease and amortisation rate of the leased assets reported under IFRS 16, which may be quite different from the underlying cash payments. Our analysis will therefore continue to be based on the actual cash rental paid.

The inclusion of operating leases on the balance sheet may make some companies reconsider their use, but these instruments have other potential advantages over direct ownership. Operating leases can offer more flexibility, for example where a business line has yet to establish itself the lease obligation can be exited if the line ceases. Leasing can also provide some flexibility to reduce or increase assets in line with the business cycle. Operating leases also alleviate refinancing risk, as the funding profile is effectively amortising rather than bullet repayments. But unlike an owned and pledgeable balance-sheet-funded asset, no asset is owned at the end of the operating lease.

The new reporting standards will result in higher reported leverage, but we do not think there is a significant risk of borrowers breaching loan covenants. Many covenants will continue to be tested under the accounting rules in force when the covenant was agreed. Where covenants need to be renegotiated a relatively smooth transition should result from the fact that the company's economic position is unaffected and that implementation is not until 2019.

For a detailed explanation of our approach, see our report "Treatment of Operating Leases in Corporate Analysis" available at www.fitchratings.com.