The Financial Accounting Standards Board’s new lease accounting standards announced earlier this year will require public companies to recognize assets and liabilities from operating leases on their balance sheets for fiscal years beginning after December 15, 2018.
The changes — a response to a growing need to provide more transparency to off-balance sheet leasing obligations, estimated at some $1.2 trillion dollars — will impact not just accounting policies but lease vs. buy decisions within IT organizations whose companies will have to comply with the new standard.
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Before the new rule, only capital leases were required to be reported on balance sheets. Looking ahead, all leases must be recorded as liabilities. As a result, says Steven Kirz, managing director with business transformation and outsourcing advisory firm Pace Harmon, “companies that were attracted to leasing in order to keep significant assets off the balance sheet may be less interested in leasing in the future. “
It’s just the latest shakeup in the IT equipment leasing industry which has also been reeling from reductions in the cost of IT equipment and increased adoption of cloud computing. “The profits of the companies that lease IT equipment are under pressure,” Kirz says. “At the same time, cloud adoption is shifting lessor relationships from the end-client to the cloud provider, and many cloud providers are building their own data centers with commodity equipment, thus shrinking the lessors’ market size.”
The upside to the new lease accounting standards
In the face of these trends, a number of large independent leasing companies have recently sold themselves to large banks resulting in market consolidation. Crestmark Bank bought equipment-leasing company TIP Capital in late 2014. Huntington Bank acquired Macquarie Equipment Finance last April. And Wells Fargo purchased GE Capital Vendor Finance in March.
While the new leasing accounting standards may eliminate the upside of IT equipment leasing for some organizations, the shifting conditions in the leasing industry could offer some opportunities for those that chose to lease in the future. Lessors are likely to be more amenable to meet client demands in contract flexibility, says Kirz. What’s more, leasing companies are also developing new value-added services to differentiate themselves in an increasingly competitive market, according to Kirz. Some are offering free software to track inventory, assistance in swapping out assets at the end of leases, and state-of-the-art data cleansing and disposal, as examples. “What has not changed is that over the long-term, leasing reduces IT equipment cost by approximately 10 percent, while keeping IT hardware life at 36 months or less,” Kirz says.
The downside to the new lease accounting standards
The pitfalls associated with IT leasing also remain the same. “The most obvious problem is that in order for leasing to make financial sense, you have to be able to track the assets throughout their life to be able to return them,” says Kirz. “Beyond this issue, what many companies do not understand is that there is a broad spectrum of lessors and associated leasing contract terms; this is not a market in which there is a standard contact.”
At one end of the spectrum are lessors that produce profits through the re-sale of the returned equipment; at the other are those that make their margins through onerous contract terms that reduce the financial or technology currency benefits that leasing can provide.”
Smart IT leaders will develop a rigorous business assessment of the benefits of buying vs. leasing in the current environment before making a decision as a start. “To avoid the risks and pitfalls associated with leasing, customers must be prepared to invest in the internal resources required to track assets,” advises Kirz. “In addition, we recommend customers use RFIs and RFPs with a focus on flexible contract terms, elimination of onerous terms, and the inclusion of value-added services in order to differentiate one group of lessors from the other.”
IT leasing red flags
IT leaders should steer clear of these contract terms when leasing technology equipment.
- Pro-rated charges applying to all equipment from installation of last equipment to start of lease term.
- Interim rent charged against all equipment based on final installation.
- Excess penalties and charges for early termination of lease.
- Requirement for equipment to be insured and threat of automatic insurance provision triggered.
- Penalty provision for lease termination due to casualty or loss.
- Charges for all document and filing fees.
- Shipping charges to multiple destinations.
- Like-kind returns not specified or excluded.
- Any terms specifying a residual value guarantee or “remarketing fee.”
Source: Pace Harmon