The Leasing Illusion
Changes loom menacingly in the land of lease accounting. Be afraid… or not.
Many fiercely oppose pending changes to lease accounting, changes that would make leases look more like purchases on financial statements. While it may cause temporary turbulence with bank covenants and the like, I see a silver lining: because these changes make leases look less attractive on financial statements, I predict that many companies will make better decisions on their equipment and IT investments.
Why? Because many bad projects, projects with negative value if purchased, magically appear profitable if leased. “Appear” is the operative word because the profit is likely an illusion.
The two biggest warning flags are:
- “Leasing improves financial ratios.” Certainly, some accounting ratios almost always look better under leasing. But accounting metrics are the wrong tool for evaluating medium and long-term investment decisions. Let’s stick with the proper finance tools for capital investment decisions.
- “It had a higher NPV.” At least now we are using the right tool (Net Present Value), but it has probably been mishandled. I’ll minimize the finance mumbo-jumbo and just say that we can’t use our ‘normal’ discount rate. When we use the normal discount rate, we under-estimate the true cost of the lease. When I raised this issue at a recent roundtable, one banker regarded me with visible distain and stated, “It’s basic Finance 101; all cash flows are run at WACC” (WACC is the ‘normal’ discount rate). I refrained from suggesting he should have stuck around for Finance 401 to tackle hairier issues like leases.
The best practice for avoiding errors is to base project approvals on purchase scenarios. Only after clearing that hurdle should we consider whether leasing is the preferred financing arrangement. However, if projects had a low or negative values if purchased but were approved based on a leasing scenario, it’s a good bet that those projects were mistakes.
It’s Never Over
The new accounting rules may temporarily curtail leasing, inadvertently reducing the number of bad projects that sneak through approval. However, leasing is an industry known for its creativity in ‘financial engineering.’ We will likely see new structures evolve that artfully dodge the new rules and the threat of errors return.
In any event, decision-makers need to keep up their guard when asked to approve projects employing leasing or any other fancy financing maneuvers. In every case ask the question, “What is the project value if we purchase the equipment outright?” If the project is a loser as a straight purchase, it is almost guaranteed that the fancy financing is simply concealing a bad project. If you would like to explore this further, drop me a line.
©Verax Point Consulting, LLC