Fitch Says New Lease Accounting Standards Won’t Affect Ratings

The new lease accounting rules released by the Financial Accounting Standards Board will not affect credit ratings by Fitch Ratings, according to the nationally recognized statistical rating organization.

Fitch said in its analysis of operating leases, it capitalizes 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 Fitch believes their approach 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, Fitch says it generally expects 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. Due to this, Fitch expects to continue adjusting companies’ reported figures to create a debt equivalent.

The 8x multiple Fitch often uses can be adapted to reflect the nature of the leased assets. Fitch applies 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 capitalize operating leases where we see them more as an operating cost than a payment under a longer-term funding structure.

The new lease accounting reporting standards will result in higher reported leverage, but Fitch does 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.

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