Impacts of a New Lease Accounting Standard for the Mid Sized Business

Impacts of a New Lease Accounting Standard for the Mid-Sized Business

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CONTENTSAbout This Report ..............................................2

Using Leasing to Help ........................................3Grow Your Business

Business Needs Come First................................4

Reexamining Financing ...................................... 5Options After the Change

Does Forewarned Translate ............................... 7into Forearmed?

Getting Ready for Change ..................................9

Sponsor’s Perspective ..................................... 10

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ABOUT THIS REPORTIn August of 2015, CFO Research surveyed senior finance executives at small and mid-sized companies in the United States, examining the impact that the proposed accounting change to move operating leases onto the balance sheet might have on those companies’ business deci-sions. This report is based on 158 survey responses from finance execu-tives at U.S. companies with between $25 million and $1 billion in an-nual revenues.

The survey and this report, which were sponsored by the middle mar-ket lender CIT Group, represent views from a broad range of compa-nies, as follows:

TITLEHead of finance (CFO, finance director, or equivalent) ......................... 72%CEO, president, managing director, or equivalent .........................................11%Controller .............................................10%Treasurer ................................................ 3%Other executive with finance responsibilities ...................................... 3%Other ..................................................... 1%

REVENUE$25 million - $99 million ....................... 33%$100 million - $249 million................... 33%$250 million - $499 million .................. 23%$500 million - $749 million ................... 7%$750 million - $1 billion ..........................4%

INDUSTRYFinancial services/Insurance ................ 13%Wholesale/Retail trade ......................... 13%Auto/Industrial/Manufacturing ............11%Construction ..........................................8%Business/Professional services ...............8%Health care............................................. 7%Education ...............................................6%Transportation/Warehousing ................. 5%Government/Public sector/Nonprofit .....4%Chemicals/Energy/Utilities ....................4%Real estate development ........................4%Food/Beverages/Consumer packaged goods .....................................................4%

Hardware/Software/Networking............ 3%Telecommunications .............................. 2%Pharmaceuticals/Biotechnology/ Life sciences ........................................... 2%Media/Entertainment/Gaming ............... 2%Natural resources/Mining ...................... 1%Aerospace/Defense ................................ 1%Travel/Leisure ........................................ 1%Other ..................................................... 1%

OWNERSHIPPrivate ..................................................63%Public ................................................... 15%Nonprofit ..............................................11%Subsidiary of a U.S. corporation .............. 5%Government ...........................................4%Subsidiary of a foreign corporation ........ 2%

ACCOUNTING STANDARDU.S. GAAP ............................................93% Modified U.S. GAAP ................................ 3% IFRS ....................................................... 2% Other ..................................................... 3%

Note: Percentages may not total 100% due to rounding.

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USING LEASING TO HELP GROW YOUR BUSINESSFor many companies, it appears that leasing is here to stay. Especially for mid-sized companies that are growing and striving to succeed, finance executives view leasing as an important financing strategy.

However, the Federal Accounting Standards Board (FASB) is working on a change in the lease accounting standard that is giving finance executives reason to pause and reexamine their financing options. The proposed change would move all long-term operating leases onto the balance sheet as non-debt liabilities. At this point, finance executives have questions about how the change would impact their reporting of liabilities, and

potentially alter key financial metrics such as ROA, debt-to-equity, and cash flow. For this reason, they also have questions about the proposed accounting change’s ripple effects on operating decisions and on a company’s ability to meet the terms of previously negotiated bank covenants.

To help gauge the potential scope of these concerns, CFO Research, in collab-oration with CIT Group, surveyed finance and corporate leaders from small and mid-sized U.S. companies. The message from the 158 respondents who participat-ed in the survey is loud and clear: Leases, and in particular operating leases, are core elements in many of their growth strategies, and so it will be important to understand the consequences for their business of changing the accounting standard.

The survey shows that almost two-thirds (65%) of respondents rank leas-ing as either critical to or an important part of their company’s growth over the next two years. (See Figure 1.) Mid-sized companies, such as those represented in our survey, are eager to grow, too. About one in five respondents (18%) say their companies have aggressive growth plans over the next two years, and more than half (53%) have moderate growth plans.

As an example, one respondent—the head of finance for a mid-sized, private

FIGURE 1

FOR A MAJORITY OF MID-SIZED COMPANIES IN THE SURVEY, LEASING IS AN IMPORTANT PART OF GROWTH STRATEGIES.

Leases (large-ticket equipment or vehicles, real estate, other) will be ___ for my company’s growth over the next two years.

Percentages of all respondents.

■ Critical or important ■ Minor, not important, or not sure Other

17%

What types of leases will be important or critical to your company’s financial strategy?

35%65%

Real estate 24%

Large-ticket equipment or

vehicles 23%

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By far, the largest number of respon-

dents (45%) say that they primarily uti-lize operating leases, rather than capital leases, and another quarter (23%) utilize a mix of both. Many finance executives prefer operating leases, in particular, for the operational and financial flexibility they provide. (See Figure 2.)

Cash flow requirements (selected by 43% of respondents) and operational requirements or business growth (41%) are the two most important factors driv-ing mid-sized companies’ decisions on whether to increase or decrease leasing activity. “It is all about current and pro-jected cash flow,” says the head of fi-nance for a small private company in the media/entertainment/gaming sector.

financial services company—explains how leasing considerations figure into the company’s growth plans. He writes, “We employ leasing now due to the

ability to carry less debt on our balance sheet, so as to free up financing for other capital improvements.” If FASB’s proposed accounting change were to place more debt on the balance sheet, the factors in the financing equation could end up having different values for this company.

Other companies turn to leasing for direct operating benefits. The corpo-rate head of a mid-sized company in the natural resources/mining sector writes, “Large capital equipment incorporates the latest technologies and these im-prove our operating efficiencies, so we want to be using the latest equipment.” Leasing contracts afford companies like this the flexibility they need to survive and succeed in the face of rapid techno-logical advances.

It makes senses, then, that finance ex-ecutives will want to make sure they un-derstand how FASB’s proposed account-ing change may affect the calculations they use in evaluating the suitability of leasing for their particular companies.

BUSINESS NEEDS COME FIRST

“Large capital equipment incorporates the latest technologies and these improve our operating efficiencies, so we want to be using the latest equipment.”

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However, few respondents (6%) believe that the new standard will actually make leasing a more attractive financing op-tion for them, although 10% believe that

short-term leases (i.e., those not subject to the new standard) will become more attractive. A larger number of respon-dents (26%) express concern that the

REEXAMINING FINANCING OPTIONS AFTER THE CHANGE

As the head of finance for a mid-sized private company in the wholesale/ retail sector writes, “My company prefers to lease long-term assets and have the flexibility to upgrade when technologi-cal upgrades warrant it.” The controller for a small private construction company concurs, pointing out, “If the economic/business environment has changed, we are not tied to a piece of equipment we potentially may not need.”

Leasing can provide financial flexibil-ity in the service of business growth, as

well. The head of finance for a mid-sized private company in the wholesale/retail sector explains, “We are a highly lever-aged company, and leasing allows us to continue to renew our capital base with-out large outlays of capital.”

For these types of reasons, many com-panies are unlikely to change their busi-ness practices solely to accommodate the accounting change. In fact, a major-ity (65%) do not expect the new standard will force changes in their current leasing portfolios. As the head of finance from a private company in the wholesale/retail sector notes, “Presently we do not antici-pate any changes to the type or number of leases we employ.”

This finance executive goes on to ex-plain his reasoning: “We basically reach a determination based on the ROI and not how it'll be classified in the financial statement. As a private company, we do not have external pressures that influ-ence the results of operations when it comes to recording a transaction.” Or, as the head of finance from a professional services firm succinctly puts it, “We will not let the tail wag the dog.”

FIGURE 2

MID-SIZED COMPANIES IN THE SURVEY RELY MORE HEAVILY ON OPERATING LEASES THAN ON CAPITAL LEASES.

Overall, which types of leases does your company currently employ the most?

Percentages may not total 100% due to rounding; 19% said "Neither."

■ Primarily capital leases ■ Mix ■ Primarily operating leases

Capital leases Operating leasesMix

45%23%13%

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new lease accounting standard will make leasing a less attractive financing option, and slightly fewer than one in five (18%) expect their current leasing portfolios will decrease.

Many respondents express their dis-pleasure with the anticipated cost and disruption involved with changing their financial statements. In that way, writes

the head of finance for a mid-sized pub-lic company in the pharmaceuticals/biotechnology/life sciences sector, “The new standard makes leasing less attrac-tive than it is today due to the complexity and work required by the new standard.” Ambitious mid-sized businesses are un-derstandably reluctant to commit scarce resources to reconfiguring their books

when they can be better deployed in pur-suit of growth opportunities.

The most dramatic opinion is ex-pressed by the head of finance for a small private construction company (less than $100 million). This respondent writes, “[T]he attractiveness of operating leases on vehicles will evaporate….Operating leases are a more costly option without any positive balance sheet impact.” As an alternative, he continues, “We'll finance, own, and then sell the asset down the road”—essentially forcing this company to trade the flexibility of leasing for the challenges and risks of ownership.

When asked to express their prefer-ences (if any) for alternative financing arrangements, respondents clearly opt for debt financing or cash flow over eq-uity financing. (See Figure 3.) More than a third (36%) would be more likely to em-ploy debt financing; 30% would be more likely to use operating cash flow; and 10% would be more likely to employ eq-uity financing. (Note that these choices were not exclusive of each other, and so some respondents selected more than one.) “We will go from leasing to buying,” says the controller for a mid-sized private manufacturing company.

Even companies that keep up their lease portfolios will feel some degree of fallout from the accounting change. At the very least, says the corporate head of a mid-sized transportation company, “Leases will be renegotiated to comply with acceptable lease standards.” Anoth-er respondent, who is the head of finance for a mid-sized private construction com-pany, writes, “Currently, the debt/lease decision may change somewhat. Prob-ably [our] largest concern is [the] impact upon bank covenants, bonding capacity, and other areas of that nature.”

FIGURE 3

FINANCE EXECUTIVES WOULD PREFER DEBT FINANCING AND USING OPERATING CASH OVER EQUITY FINANCING, IF THEY WERE CONSIDERING ALTERNATIVES TO LEASING.

If the new lease accounting standard is implemented, which of the following alternative financing strategies, if any, are you more likely to employ instead of leasing?

Percentages may not total 100% because multiple choices were allowed.

None of the above; the changes in the standard won’t affect our

consideration of alternatives to leasing

Other

Equity financing

Operating cash flow

Debt financing

40%

1%

10%

30%

36%

“Probably [our] largest concern is [the] impact upon bank covenants, bonding capacity, and other areas of that nature.”

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DOES FOREWARNED TRANSLATE INTO FOREARMED?

For certain companies, finance execu-tives express concern over whether the consequences of the accounting change could even extend to how manage-ment and stakeholders evaluate busi-ness performance. The head of finance for a business services company writes, “We lease real estate for both store and

Uncertainty is one of the most commonly cited sources of respondents’ discomfort. It may be a case of fearing that what they don’t know could very well hurt them.

“We lease real estate for both store and warehouse locations as well as over 200 trucks—we have good business reasons for leasing and the new accounting rules do not impact those. [But] it will have very broad implications for the benchmarks that we use to measure our business success.”

More than four in ten (43%) report feeling left in the dark—nearly a quarter (23%) of the respondents say that they do not feel very well informed about the

warehouse locations as well as over 200 trucks—we have good business reasons for leasing and the new accounting rules do not impact those. [But] it will have very broad implications for the bench-marks that we use to measure our busi-ness success since Return on Net Assets (RONA) is a key performance indicator and management bonus component.”

A few respondents—including some who may continue to employ leasing—go so far as to say that they fear the cost of making the accounting change will be high enough to pose a potential threat to their companies. The head of finance for a mid-sized private company in the wholesale/retail sector sums up these concerns when he writes, “The assets we currently lease are critical to our busi-ness. As such, we'll have to continue to acquire [them], either through lease or purchase….The cost, both monetarily as well as structurally, of renegotiating our banking covenants to accommodate this standard will likely be significant enough to slow our forward momentum.” How much these fears will be borne out in the final FASB proposal and during the imple-mentation period remains an area of uncertainty for the finance executives in the survey.

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Impacts of a New Lease Accounting Standard for the Mid-Sized BusinessFIGURE 4

MANY FINANCE EXECUTIVES FEEL UNDERINFORMED ABOUT THE IMPACTS THE PROPOSED ACCOUNTING CHANGE MAY HAVE ON THEIR COMPANIES.

How well informed do you feel you are about the proposed changes in the lease accounting standard, and how they will affect your company?

Not applicable

Very well informed

As informed as I need to be

Not very well informed

It’s still too early to tell

23%

32%23%

20%

3%

Percentages may not total 100% due to rounding

impacts of the new accounting standard on their companies, and another 20% say that it’s too early to tell, so they are wait-ing for a final decision before evaluating the impacts. (See Figure 4.)

FIGURE 5

RELATIVELY FEW COMPANIES IN THE SURVEY HAVE ALREADY TAKEN ACTION TO ESTIMATE THE IMPACTS OF THE PROPOSED ACCOUNTING CHANGE ON THEIR FINANCIAL STATEMENTS.

Has your company modeled the potential impact of the proposed changes [in the lease accounting standard] on its financial statements?

I’m not sure

No, and we have no plans for evaluating the impacts

No, but we plan to evaluate the impacts at the appropriate time

Yes, at the level of estimating impacts on specific line items

Yes, we have done detailed modeling or developed pro forma statements

13%

2%

41%

37%

7%

In fact, nearly eight out of ten respon-dents (78%) have yet to evaluate the po-tential impact of the proposed changes on their financial statements—41% plan to evaluate impacts “at the appropriate time,” and 37% have no plans to evaluate impacts at all. Only 20% of respondents have already performed detailed model-ing of the impacts, developed pro formas, or estimated impacts on specific line items. (See Figure 5.)

While they wait, most of the respon-dents (73%) say their companies will “continue with business as usual”—probably out of necessity, as no company can afford to sit idle while waiting for res-olution. But the fallout from this degree of uncertainty, writes one executive in the survey, is that he will be approaching the implementation of the new standard “with a lot of caution.”

Others express similar views, and 45% of the respondents either do not believe their companies are well prepared to adapt their financing strategies to the proposed change (34%), or simply don’t know if they are prepared (11%). Even at companies where leasing is an important part of growth strategies, similar num-bers of finance executives say they are not feeling prepared.

In some cases, the continuing uncer-tainty surrounding the implementation of the new standard is also causing mid-sized companies to put off making any changes to the status quo until they have better information. “We are growing so quickly but are really uncomfortable with the current US regulatory environment [and so] we can't plan our leasing activity too far in advance,” notes the corporate head of a mid-sized, public financial ser-vices firm.

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GETTING READY FOR CHANGEIn playing the waiting game, companies may be at risk of falling behind. Even if the proposed accounting change doesn’t alter the outcomes of financing deci-sions, it stands a good chance of altering the process of making those decisions. Finance executives will need to prepare themselves and their companies for the additional complexity of weighing their financing alternatives, as well as the ad-ditional costs involved in switching over.

To make sure they are well prepared to continue to take full advantage of the value and flexibility that operating leases provide, finance executives at mid-sized companies may need to ask themselves several key questions about the role that leasing plays in their financing strategies and how the upcoming change in the ac-counting standard can affect those delib-erations.

1 What are the key metrics underlying your financing decisions?

How will the accounting change affect those factors?

2 Will your company need to trade off operational and strategic benefits

of leasing with the cost of implementing the accounting change?

3 How ready is your company to act when it needs to?

Do you have a good idea of how much time and effort it will take your company to adapt to the new standard?

4 Do those responsible for setting the direction for your company—

your C-suite, board, owners, and shareholders—understand what will change for your business, and what won’t?

5 What can you and your finance team do now to prepare

yourselves, and others in your company, for making the transition with the least disruption to your business?

5 KEY QUESTIONS


10

SPONSOR’S PERSPECTIVEThere are many things for organizations to consider when evaluating whether to lease or buy the equip-ment required to run their operations. Despite potential upcoming changes in lease accounting, the ben-efits of leasing remain.

Leasing offers a multitude of financial, strategic, and operational benefits when compared to incurring 100% of the expense upfront, as is the case with outright purchase. Manageability, security, taking advantage of the latest innovations, upgrade flexibility, operational flexibility, conservation of capital and lines of credit, reducing environmental disposal risks, and budget and payment flexibility are among them.

When undertaking a lease versus buy analysis, it’s important to factor in maintenance and support costs as well as “end of life” costs such as decommissioning expenses. A study by market research firm IDC suggested that many times, these are not factored in appropriately. When purchasing and holding onto equipment for longer periods of time, maintenance costs rise. These cost increases are driven by two key factors:

• Mechanical failures—as machines age, they have many more maintenance "events" resulting in high-er expense

• Unbudgeted or unplanned costs of updating software configurations as updates become available or infrastructure changes

Leasing makes it easy to acquire, manage, and control assets. Here are 5 reasons to lease:

1. Protection Against Advancing TechnologyLeasing enables you to stay on top of technological advances with minimal financial impact or risk, and deliver increasing value to your customers while staying ahead of your competitors. You can add-on or upgrade during the lease term. At the end of the lease, choose to return or purchase the equipment.

2. Predictable, Low Monthly Payments Leasing enables you to pay over time, rather than invest a lump sum up front. Lease payments can be tailored to budget levels or revenue streams and may be tax deductible.

3. Lower Upfront Costs Leasing reduces upfront costs, enabling you to obtain the assets you need now without impacting cash flow. It preserves working capital and existing credit lines, freeing up cash for other operational expenses.

4. Flexible Pay Structures Leasing provides flexibility that purchasing does not offer, including: 100% financing with no money down, payment structures that match cash flows or business cycles, and a variety of end-of-lease options.

5. Ability to Bundle Costs Leasing offers you the ability to finance hardware, software, and services in one transaction. The convenience of one-stop shopping offers an immediate, affordable way for you to meet your business needs.

For more information about financial solutions for the middle market from CIT, please visit www.cit.com

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Impacts of a New Lease Accounting Standard for the Mid-Sized Business is published by CFO Publishing LLC, 295 Devonshire St., Suite 310, Boston, MA 02210. Please direct inqui-ries to Linda Klockner at 617-790-3248 or [email protected]. CFO Research and CIT Group developed the hypotheses for this research jointly. CIT Group funded the research and publication of our findings. At CFO Research, David Owens directed the research and wrote the report. CFO Research is the sponsored research group within CFO Publishing LLC, which in-cludes CFO magazine, CFO Conferences, and CFO.com. October 2015 Copyright © 2015 CFO Publishing LLC, which is solely responsible for its content. All rights reserved. No part of this report may be reproduced, stored in a retrieval system, or transmitted in any form, by any means, without written permission.

Impacts of a New Lease Accounting Standard for the Mid Sized Business

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