The coronavirus crisis puts to the test the new revolutionary lease model, under which all operating leases are recognized in the balance sheet. The fact that more property owners are making concessions to their lessees than other credit providers suggests that some leases are in substance more akin to relationships with suppliers and service providers (operational relationships) than to relationships with financial creditors. An example of such a “soft” liability can probably be found among lessees who are retailers. When we come out on the other side of the crisis, it is only appropriate that accounting standard-setting boards (IASB and FASB) rethink this topic as part of the process of drawing lessons from the crisis.
The coronavirus crisis is currently putting the young lease accounting model to a global legal-business test across many sectors. The world’s leading accounting standard-setting boards (the IASB and FASB) are currently engaged – and rightly so – in granting practical expedients to lessees in respect of concessions received from lessors as a result of the crisis. But it is exactly such concessions that could induce the accounting standard-setting boards to rethink and improve the accounting model that created new financial liabilities in lessees’ balance sheets. It should be noted that this issue is relevant to balance sheets of US-based companies (since under US GAAP, the new model was only applied to the balance sheet – a “hybrid” and somewhat peculiar approach), and even more so to companies applying IFRS, since IFRS 16 adopted the new accounting model in full (for other sections of the financial statements).
As is well known, the new financial liabilities recognized in balance sheets during the course of the last year as a result of the new accounting model are thought by investors to have multiple potential consequences, including, among other things, due to their effects on basic financial ratios such as leverage and profitability. The potential consequences may even apply to valuation and share pricing, mainly because under the new model, lease payments are classified as financial payments, whereas under the old model – they were classified as an operating expense.
It is already evident that, although some lenders tend to give borrowers concessions by deferring loan repayments (including accrual of interest on the deferral itself), lessors tend, in certain cases, to give lessees concessions by waiving a certain percentage of the rent altogether. If what we will see unfolding will be more concessions given by property owners to their lessees than by other credit providers, this suggests that leases are more akin to relationships with suppliers and service providers (operational relationships) than to relationships with financial creditors. The theoretical basis for giving the concession is that the service (use of the asset) was not rendered, which is not the case in non-operational financial relationships, such as when taking out bank loans. Let us assume, for example, that a moving company takes a bank loan in order to buy a truck. Now let us assume that, for security reasons, the government bans the use of roads for a period of two months. In this case, one can assume that the moving company’s demand from the bank to waive loan repayments will be fruitless, since the bank is not involved in the disrupted moving services, but rather merely in providing credit services, which continue as usual. On the other hand, if the truck were leased, then – in view of the operational nature of the lease – there is an implicit underlying assumption that the moving company is required to pay the lease payments only to the extent that the lease services continue uninterrupted. This underlying assumption is similar in substance to the offsetting right, thereby it undermines the new lease model’s applicability to lease transactions that are operational in nature. As is well known, binding agreements with suppliers and service providers are currently not reflected in the same way as in the new lease model; thus, the concessions given by lessors highlight the fact that relationships with certain lessors are operational in nature (a “soft” liability) rather than financial.
We may therefore reach the conclusion that a distinction is needed between different types of lease agreements along the lines of the old lease model, but with significant improvement, and such a distinction will be based on the extent to which the lessor shares operational risks with the lessee. It can be assumed, for example, that in the case of leases where the lessee is a retailer, the lessor-lessee relationship is more operational in nature – which may be reflected in the lessor’s waiving lease payments if the store is closed or if very few shoppers frequent it. In substance, this can be compared to a situation where the lease includes variable lease payments, which – as we know – are not recognized as part of the right-of-use asset (to the extent that they do not depend on an index or a rate). On the other hand, the lessor-lessee relationship is more financial in nature when the term of the lease is not considered short as compared to the useful life of the asset in sectors such as aviation and marine transportation, where the interaction between the lessor and the lessee is also minimal. In such cases, the lease is, indeed, similar in nature to purchasing an asset by way of a loan.
A Financial Liability Across-the-Board?
It may very well be that the new model was too extreme in the first place. Thus, overwhelmingly treating lease liabilities as financial debts entails many disadvantages and leads to many problems that will arise at a later stage. Long before the coronavirus crisis, CFOs of retailers claimed that leases are “soft” liabilities, and that in the event of a severe economic crisis, the lessor will have to “waive” the rent, and will only rarely demand that the lessee evacuate the property. The CFOs claimed that under no circumstances can such leases be treated as ordinary financial liabilities. Moreover, the great difficulty we encounter when trying to compare a liability recognized for many lease contracts to an ordinary financial liability can also be viewed from other perspectives:
- Unlike in the case of financial instruments, variable lease payments may not be included in the liability under the new model. In the aftermath of the crisis, it may very well be that more leases will include such risk-sharing mechanisms, since even when charging fixed rent, lessors appear to be sharing the lessee’s risks, and are forced to give concessions in times of crisis. This may drive lessors to demand the right to share not only the risks but also the benefits arising from the asset when entering into new leases; such benefits may include an unexpected increase in turnover and profit.
- As is the case of financial instruments, lease payments are normally discounted by the lessee’s incremental borrowing rate (as if the liability was purely a financial one). However, in practice, this debt is not a purely financial one, and involves exposure not only to the lessee’s financial position, but also to its operating activities. Therefore, in economic terms, the correct way to discount the lease payments would be by using the interest rate implicit in the lease rather than the lessee’s incremental borrowing rate. The reasons for that may be varied – the lessee’s default risk, in which case the asset is recovered or may be leased out again – which exposes the lessor not only to historical rent, but also to the current rent. Indeed, it is clear that ordinary debts (especially non-recourse ones) are exposed to the activity of specific assets; however, in the case of leases, the exposure stems from a specific asset rather than from the activity of an entire company.
- It is hard to envision a situation where in a liquidation of a company the court will grant the “right-of-use” implicit in a specific lease to a specific buyer or divide it among the creditors, while treating the lessor giving such right as a general creditor. It is reasonable to assume that the lease will be terminated, and a tort claim will be filed. Thus, since the lessor’s exposure to the asset is greater than in the case of standard loans, he will therefore be more willing to give concessions to the lessee.
Lease vs. Service Contract
Recognizing leases in companies’ balance sheets led to a lack of coherence regarding the continued treatment of service contracts as off-balance sheet contracts. The explanation given to this divergence in IFRS 16 is that the lessee gains control over the right-of-use asset at the lease commencement date. According to this rationale, as from that date, the lessee may unilaterally direct the use of the asset and make relevant decisions such as those pertaining to the timing, nature and cost of constructing leasehold improvements. As a result, as from the lease’s commencement date, the lessee has an unconditional obligation to pay the rent to the lessor. This is not the case in a service contract, such as a contract for the provision of security and cleaning services over a three-year term. In such a contract, the customer does not control the economic benefits arising from the service before it is actually being rendered. Thus, in a service contract the customer has an unconditional obligation to pay the supplier only in respect of the service rendered to date. Based on this rationale, a service contract does not normally include an identified asset, so no control of any asset is transferred to the customer on day one.
The abovementioned rationale – which is based on identifying a specific tangible asset – was not very clear in the first place, at least in my opinion, not to mention the fact that there is no difference on the liability side, so it is safe to assume that in both instances there is no legal obligation to continue paying for the services when the services are not rendered – both in the case of leasing services and security and cleaning services. It is unclear what the exact distinction is between a contract for the provision of services and a contract for leasing a store. After all, in the case of a service contract too, decisions are made based on the contract from day one of the contract. To illustrate this point, let us consider a three-year agreement for the provision of construction services between a contractor and a subcontractor. Based on the legal right to receive construction services from the subcontractor, the contractor makes decisions from day one, such as regarding the advertising of the project and the selling of apartments off-plan. In that context, controlling the contractual right to receive construction services and the decisions made based on such control are not substantively different from controlling the right-of-use asset in a lease. Consequently, at least in the case of leases which are operational in nature, the existence or absence of an identified underlying asset is a mere formality, and therefore – since the conceptual framework’s principles for recognizing assets is based on the concept of control – such absence or existence should not lead to a different accounting treatment in terms of recognizing an asset in the balance sheet.
Improving the Model
Although it took standard-setting boards many years to develop this new accounting model, it is only appropriate that they rethink the model following the coronavirus crisis. The conclusions drawn from this test of reality can give us the tools to improve the accounting model in the future, such that it will be consistent with the accounting treatment applied to service contracts as off-balance sheet contracts. Our aim must be the creation of a uniform and consistent accounting model that will be applicable to leases, service agreements and other intangible assets.
This does not entail fully reinstating the previous accounting model, but rather clarifying the concept of control over a right-of-use asset in terms of risk sharing – such as the extent to which a lessee can, in fact, get out of a lease – including his ability to sublease the asset without first obtaining the lessor’s consent (a retailer who leases a store in a mall cannot normally do so). With regard to the previously used distinction between a finance lease and an operating lease, this can be done by setting additional criteria which are based on the nature of the lease relationship and its characteristics.
The bottom line is that a case where a lessee can, in effect, stop paying rent if the “lease services” have not been provided, or even if that lessee only has a de-facto right to reduce the rent, is similar, in substance, to an ordinary off-balance sheet contract, since it focuses on the provision of the service. There are still not enough data about what is happening in this unfolding crisis, but we are getting the sense that relationships between lessors and lessees are not the same as between borrowers and creditors, but rather, in some cases, more like service contracts. Thus, for example, some companies unilaterally inform all their suppliers that in view of the crisis, they have decided to deduct a certain percentage from all payments to suppliers (say, 15%). They will probably issue the same message to their lawyers, advertising agency, cleaning service provider and landlords, but will not be in a position to do so with lenders, such as banks and bond holders.