The latest lease accounting proposals from international and US standard-setters, designed to aid transparency and consistency, may encourage companies to shift to short-term leases or structure agreements as service contracts, according to Fitch Ratings. This could mean that fewer leases than originally anticipated will be brought onto the balance sheet when the standard is enforced in 2017.

Fitch said compromises in last Thursday’s draft exposure include an exemption allowing leases of twelve months or less to remain off balance sheet. The accounting standards boards have attempted to limit artificial structuring of long-term leases into short-term ones by specifying that the twelve months or less term must include options to extend.

Nevertheless, Fitch noted, companies may push for more short-term leases to avoid putting them into the accounts, although incremental costs and subjectivity in determining the lease term would have to be considered. Irrespective of the lease term, Fitch said it will continue to include longer-life leased assets in its debt analysis. As Fitch already treats off-balance-sheet leases largely as debt obligations, it expects any impact on ratings to be minimal.

Arrangements assessed as “service contracts” can also remain off balance sheet, Fitch said. The exposure draft establishes a strict test for deciding what gets treated as a lease. Many service contracts may fail this test, meaning that the lease standard will not apply to them. This should have minimal impact on Fitch’s analysis, as it does not normally treat service contracts as debt obligations. But this would be more difficult to analyze if companies try to convert leases into service contracts so they are kept off balance sheet, Fitch added.

Lessees may prefer not to have renewal options because they increase uncertainty in determining the expected lease term, Fitch said. The use of a “significant economic incentive” test rather than a probability test to determine whether a lease would be renewed should reduce subjectivity. But Fitch said it believes consistent application could still be challenging because of the number of factors relating to the contract, market, and the specific entity that would need to be considered.

A potential shift to short-term leases would be credit negative for lessors. Fitch said it believes short-term leases generally reduce the predictability of cash-flows for a lessor and reduce the flexibility to align the duration of funding. The proposal outlines a number of significant changes to the accounting rules used by lessors, which Fitch said it plans to address in a subsequent comment.

The global move to a single leasing model and additional disclosures should enhance comparability, and would be positive for credit analysis. Extra information about the leased assets can help analysts better understand the economic substance of the arrangement. However, even though disclosure is improved by presenting information on many long-term leases in one place, the reporting requirements are not comprehensive.

Fitch concluded that last week the International Accounting Standards Board and the U.S. Financial Accounting Standards Board published a revised exposure draft for lease accounting. The draft will be open for public comment until September 13. Fitch said it expects to provide additional comments on potential implications for rated lessors and lessees during the next few weeks.

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