Letter number 55 of December 2010
- QUESTIONS & COMMENTS
The IASB and the FASB have a joint project that is already well underway. They are seeking to carry out a root-and-branch overhaul of the method for accounting for operating and capital leases, on their usual pretext of vastly improving the financial information available to investors. In our view, this is a great leap…
. . backwards!
Once again, through sheer dogmatism, the IASB is going to make the reading of accounts more complicated, it will unnecessarily increase the work load of those whose job it is to prepare them, and contrary to what it claims without advancing the slightest bit of evidence, it will complicate the lives of those who use accounts on a daily basis. Which is why we’re saying that it's a great leap backwards.
More seriously, by complicating the accounts, the IASB and the FASB are making them more opaque and thus less credible for mere mortals, whereas the simplicity of accounts is the keystone of their acceptability.
So what’s it all about?
Currently, the economic reality:
• of operating leases, under which the owner of an asset makes it available to a lessee for a defined period in exchange for the payment of a rent and the return of the asset on expiry of the rental agreement, unless this lease is extended;
• of capital leases, under which a company makes an asset available to a lessee for a period that is close to the asset’s life span, usually with an option to purchase the asset at a price that is lower than the residual value of the asset at the end of the leasing period, in exchange for the payment of a rent on a regular basis;
is translated in the accounts by two different accounting treatments that correspond to the different economic natures of these operations.
Under an operating lease, rent paid is booked on the income statement under operating expenses.
Under a capital lease, the asset is recorded on the asset side of the lessee’s balance sheet, with a corresponding entry on the liabilities side of a financial debt that is equal to the net present value of outstanding rent. On the income statement, the rent paid disappears and gives way to financial expenses and the depreciation and amortisation of the asset. It’s as if the lessee had acquired the asset and had borrowed to do so(1). There is nothing shocking about this treatment which, on the contrary, reflects the intention of the firm which is to enter into a financial lease agreement. It will use the asset as if it were the effective owner thereof as it knows that in the end, it will become the owner, while financing the asset using debt during the interim period. For the firm, a capital lease is, above all else, a loan.
A great leap forward was made some 20 years ago when the accounting authorities decided to interpret capital leases economically, rather than in their strict legal sense (legally speaking, the lessee is not the owner of the asset). Accordingly, from an accounting point of view, it was no longer necessary to make adjustments by recording the asset on the asset side of the balance sheet and a debt for the same amount on the liabilities side, nor to restate the leasing repayments as financial expense and depreciation and amortisation. This was definitely a step in the right direction.
Now, the IASB and the FASB want operating leases to be treated in the same way as capital leases. The value of the right to use the asset will be entered on the asset side of the balance sheet. Parallel to that, a debt of a financial nature will appear on the liabilities side which will gradually be reduced. Rent will be replaced by financial expense and depreciation and amortisation, which will reduce the value of the utilisation right each year(2).
Obviously (!), the value of this utilisation right will have to be revised if a change in the economic and financial terms impacts negatively on its value, leading to a depreciation on the income statement.
The accounting standards authorities base their point of view on the following assumptions:
• a capital lease and an operating lease basically cover the same economic act and it is not normal for them to be treated differently in the accounts;
• it is difficult to draw a clear distinction, on the basis of principles and not on rules, between an operating lease and a capital lease;
• as investors make adjustments to operating leases, why not do it for them.
We’d like to voice our firm disagreement with these positions.
The spirit of an operating lease has nothing in common with the spirit of a capital lease.
A firm uses an operating lease because:
• it does not have the financial resources, either now or in the future, to buy the asset;
• it wishes to retain the flexibility of being able to return the asset when the lease expires and to rent another one which is better suited to its current and future needs, or even to purchase one;
• it prefers to allocate its financial resources, which more often than not are limited, to other areas that it deems more useful for the firm – R&D, external growth, advertising spending, etc.
A firm makes use of a capital lease because it wants to use the asset as if it were already the owner thereof, and in the long term(3), to acquire it. However, it cannot or does not wish to acquire it today, without making use of credit. Because the lender remains the legal owner of the leased asset until expiry of the contract, it is a form of credit under which the lender enjoys a very solid guarantee. This means that it is able to offer attractive interest rates to the borrower.
Accordingly, the economic and financial logic behind operating leases is totally different from the logic behind capital leases.
It is, however, true that in certain sectors, such as mass market retailing, the hotel sector and the airline sector, companies use operating leases on a massive scale, often selling assets they own outright, only to rent them back again from their new owners under operating leases. It is also true that some rating agencies and some banks adjust the accounts of airline companies and hotel groups to factor in their undertaking to pay rent, which could take a heavy toll on free cash flows. Accordingly, Standard & Poors capitalises Accor’s fixed rents, but does not adjust rents that are indexed to sales.
But why throw the baby out with the bath water? Wouldn’t it be sufficient to request that this information be included in the notes to the accounts to enable those who so wish, to carry out the adjustments that they wish to carry out. Only a small minority of investors are involved.
This treatment ends up reflecting debts on the balance sheet where there are none, because a firm that leases desks or machines to you is not lending you money, like a bond owner or banker would do. It also reflects assets, a right to occupy or to use an asset, which, for the most part, are not transferable. Displaying a great deal of naivety, the Chairman of the IASB states that this will make it possible to take the real debt levels of firms into account. He puts a figure of $640bn on this extra debt. Thanks to this measure, we could all but have avoided the financial crisis!
As for claiming that it is difficult to tell the difference between an operating lease and a capital lease, well they’ve got to be joking. What is IAS 17 for? But it is also the practical limit of conceptual definitions that pushed professionals to use rules set by the FASB, based mainly on the comparison of the present value of rents and that of the asset in question, and the term of the lease with the lifespan of the asset (4).
But of course, since these are rules and not principles, or more specifically, a principle which, in order to be applied in practice required rules, it is possible to set up structures that make it possible to get around them. But what are auditors and audit committees for if it is not to put a stop to that?
If we follow the logic of the IASB and the FASB, then why stop if we’re on the right road? Why not record an employee utilisation right on the asset side of the balance sheet (as we all owe our employers a notice period), with a debt on the liabilities side (the salaries due during the notice period). The same goes for contracts with suppliers providing for a volume of goods and services to be purchased over several periods. Like with all things, a line should be drawn that clearly separates that which falls under finance and that which falls under flexibility (operating leases). In our view, that line is where it should be now, and not where the IASB and the FASB intend to put it.
We would strongly encourage readers to state their views by contacting the IASB (www.ifrs.org).
(1) For more information, see chapter 7 of the Vernimmen.
(2) Financial amortisation of the debt remains disconnected from the utilisation right.
(3) Using the asset as if it were the owner thereof and effectively enjoying more favourable financial terms.
(4) See page 106 of the Vernimmen.
Thanks to the painstaking work of Finance Professor and researcher David Le Bris, we are able to provide you with a graph showing the French Government long-term interest rate since 1752. It shows that with the recent rate of 2.5%, we are at the lowest point since the middle of the reign of Louis XV, 37 years before the French revolution! Why so? A low inflation environment and a fear by investor of risky investments are the main reasons.
Since the publication of a well-known article by Berle and Means(1) in 1932, a lot of ink has been spilt on the problems relating to the separation of corporate control (held by managers) and ownership rights (held by shareholders). A lot of researchers have sought to assess the consequences of this separation, in particular agency(2) related problems that result there from (the interests of managers may not be fully aligned with those of shareholders). Others have suggested solutions, through incentive payments for managers, or alternative mechanisms encouraging better corporate governance.
This month, we take a look at an article(3) that exclusively analyses US dual-class companies(4). Typically, such companies have an inferior class of listed shares with a single voting right per share, and a superior class of unlisted shares with more than one voting right per share. Shares in the superior class are usually held by the company’s managers.
Masulis et al show that when two classes of shares exist, the greater the divergence between the right to dividends (cash flow rights) and the right to vote (insider control rights), the more serious the agency problems between managers and shareholders will be.
Their study focuses on a sample of 503 listed US companies between 1995 and 2002. Their analysis, which is purely empirical, arrives at the following four conclusions. When the divergence between cash flow rights and insider control rights increases:
1. Each dollar in cash in the firm’s assets contributes less to its market value.
The presence of high levels of cash has a positive impact on information asymmetry (it reduces the risks of having to pass up on profitable investments because of a lack of credit), but a negative impact on agency problems (managers have a lot more latitude in the use of this available cash).
When the insider control – cash flow rights divergence increases by one notch, the value for the shareholder of an additional dollar in cash falls by 8 cents (and may even drop to below a dollar).
2. CEO compensation increases. Exorbitant CEO compensation is a typical example of a private benefit for the manager at the expense of shareholders. Masulis et al obviously take into account other factors that are traditionally associated with high CEO compensation – size of the firm, rate of borrowing (generally, CEO compensation is lower at firms carrying very high levels of debt), sector of activity. The effect of dual-class shares remains spectacular – salaries increase by $1 million per year when insider control – cash flow rights divergence goes up a notch.
3. Acquisitions made create less value for shareholders, and more often than not, destroy value. Managers are tempted to embark on empire-building projects, even if only for prestige reasons. What happens then is that they carry out too many acquisitions. Masulis et al show that the probability of making acquisitions that destroy value increases by 6% when insider control – cash flow rights divergence increases by one notch. They also show that managers will less frequently back away from acquisitions that are not well received by the market.
4. Capital expenditures also create less value, with some funds possibly going to advance the private interests of the CEO.
There are no surprises in these results, which confirm that the existence of several classes of shares are an obstacle to value creation for the shareholder. This article does, nevertheless, suggest four ways in which insider control – cash flow rights divergence leads to a reduction in the market value of a firm.
(1) A. BERLE et G.C. MEANS, 1932, The modern corporation and private property, Macmillian, New York.
(2) For more information on agency problems, see chapter 31 of the Vernimmen.
(3) R.W. MASULIS, C. WANG et F. XIE (2009), Agency problems at dual-class companies, Journal of Finance, vol.64, p.1697-1727.
(4) Such firms account for 8% of the US market capitalisation.
Having made one bond issue, the same company can later issue other bonds with the same features (time to maturity, coupon rate, coupon payment schedule, redemption price and guarantees, etc.) so that they are interchangeable. This enables the various issues to be grouped as one, for a larger total amount. Fungible bonds offer two advantages:
• Administrative expenses are reduced, since there is just one issue;
• More importantly, the bonds are more liquid and therefore more easily traded on the secondary market. Their price is accordingly lower, as investors are willing to accept slightly lower interest rates on securities that are more liquid.
However, as most of the bonds are ultimately repayable, they do have the drawback of concentrating repayment due dates around a single date, which reduces the company’s financial flexibility.
Fungible bonds are issued with the same technical features as the bonds with which they are interchangeable. The only difference is in the issue price, which is shaped by market conditions that may have changed since the original issue. In some cases, the first coupon payment is different while the issue price is identical: the bonds only become fungible after the first coupon payment.