The cost of the IFRS Lease Capitalization initiative: A hold-up of small business in America

Posted on February 1, 2011

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The more I investigate the IFRS proposal to capitalize leasing the more I am convinced that this is nothing more than a fee creation scam that will ultimately and perhaps in certain instances irreparably harm small-medium enterprises in America.

Like the fear mongering associated with the Y2K bug, where copious amounts of money were spent to protect ourselves from what amounted to the reflection of our own fears, the IFRS move to capitalize leases will ultimately affect balance sheets and likely lead to an increase in the cost of borrowing money from the banks.

An oversimplification perhaps, but think of it this way . . . I have a lease for 5 years with an option to renew for another 5 years.  Based on what the IFRS is proposing, the liability for the entire 10 years has to be recorded on my books today.  Think of the impact on the balance sheet for the majority of small-medium enterprises.

Now the logic behind this is that a signed lease is a contract, and therefore a legal responsibility for the company and by instituting these new standards claims the IFRS, there will be greater transparency regarding the true liabilities of the enterprise.  Of course this will affect the balance sheet from an EBITDA standpoint – and not in the positive sense.  How will the banking industry respond to this?  How will your banker react to a significant increase in your recorded liabilities with the same current revenues?  The ratios by which you obtain credit are bound to change.

Being a curious fellow, I then asked if a lease contract period and subsequent renewals must be captured and recorded up front – again bearing in mind that if you have a 5 years lease with the option to renew for another 5 years we are talking about 10 years worth of lease payments being recorded as liabilities today, why aren’t contracts related to revenues also captured in a similar fashion and recorded as such on the balance sheet?

In essence, if I have a 5 year contract that pays so much will  the total value of the contract be recorded today on my balance sheet and recognized as revenue in my EBITDA calculation?

This of course raises an interesting question given the fact that in its early days Oracle’s practice of recording sales in such a manner led to a mismatch between cash and revenues and almost sunk the company while generating class action law suits.

What the Oracle example produced, besides an inflated balance sheet, is that you do not record future earnings on contracts beyond a certain  reasonable period because said revenues may not materialize.

So why does a revenue producing contract carry less creditability than a lease contract?  Both are contracts and both can be and have quite frankly been broken in the past?  Is the IFRS suggesting that sales contracts bringing revenue into a company is somehow not as sure as the expenses going out of a company?

Does the IFRS have data that shows that revenue producing sales contracts are broken more frequently than lease contracts.  I mean let’s face it, if you suddenly find yourself without revenue how secure are your leasing contracts?  Without revenue, you cannot pay leases – unless of course there is a new math out there to which I am not privy?

Think about it for a minute . . . you lease office space, equipment etc. as a means of producing revenue.  It’s like love and marriage in that you cannot have one without the other.   How can you then claim in the name of transparency – transparency for whom is another question as the majority of companies affected by this are not public enterprises so you have to ask who is being protected here – that a lease liability that is entirely dependent on revenues coming in to the company to be honored is captured and recorded on the company balance sheet in such a fashion?

Once again, the above example is admittedly an oversimplification of a perhaps by design complex issue however, it at least poses what are both reasonable and understandable questions.

Unfortunately, reasonable and understandable answers seem to be lacking in terms of the IFRS initiative.

For example, why is the IFRS instituting these new standards relative to capitalizing leases?  What is the cost in terms of businesses having to restate their past balance sheets as well as the impact on the cost of borrowing money?  Finally, and this is the big question mark . . . what are the benefits of making this change and, who is going to benefit from this change the most?

At this point, and I am going to continue digging into this matter like the proverbial dog looking for a bone – I have to tell you that the scent I am picking up is that something is seriously amiss and for some reason the recent Wall Street escapades comes to mind.

Stay tuned!

An IFRS Hold-up of American Small Business?

 

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Posted in: Commentary