Regulatory and accountancy reform is giving rise to a surge in
take-up of operating leases. So much so that one day the
distinction between operating and financial lease will no longer
exist
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The balance of power is shifting in the leasing market.
In light of recent tax changes under IFRS, and as assets become
increasingly technical demanding continual renewal and advancement,
operating leasing – the once overlooked partner of the simpler,
more historically fashionable financial lease – is making its
mark.
On average, leasing companies and leasing associations
throughout continental Europe and the UK have reported an increase
in the use of operating leasing in recent years, and a rise in the
product’s share of the leasing market.
According to the UK’s Finance & Leasing Association, the
volume of operating leases was around £500m for July 2007, up 5 per
cent year on year and 24 per cent up on the previous month. The
volume of finance leasing meanwhile totalled £400m for July 2007,
down 3 per cent on the month and down 26 per cent on the year.
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By GlobalDataUK banks’ leasing subsidiaries such as Barclays Capital, which
performs structured and large ticket asset finance, and HSBC Asset
Finance, have also seen a rise in the level of operating leasing.
Barclays recorded a 9 per cent increase in operating lease rentals
to £345m for 2006, and Derren Sanders, managing director of HSBC
Asset Finance, says that operating leasing constitutes 10 per cent
of the business, predominantly in the rail and vehicle finance
sectors, and is set to increase due to regulatory clauses on
capital allowances.
Furthermore, according to Leasing Life’s survey of 40 UK Leasing
SMEs, published in its August 2007 issue, 45 per cent of
respondents use operating leases, and operating lease in turn
constitutes, on average, a healthy 25 per cent of their book.
According to Rudolf Fric, president of the Austrian Leasing
Association, operating leasing in the Central and Eastern European
region has doubled year-on-year since 2005.
Western growth
But this growth is confined only to the large, western-based
leasing companies in the CEE, because they have a mature skill set
and accounting methods that operating leasing requires, and can
also take residual value risk.
Craig Pickering, principal consultant at the FLA, says:
“Operating leasing is certainly on the rise, and we have seen
particularly strong growth in the UK. It is also on the rise in
continental Europe, though it started there from a very low
level.”
The Polish market has seen a 10 per cent year-on-year increase
in operating leasing, to comprise a current 5 per cent of the total
lease volume, and in Slovakia operating leasing comprised 14 per
cent of total leasing, with over 5,000 contracts signed in
2006.
Rental and accounting advantages are the key reasons for the
apparent increase in operating leasing in the asset sectors where
it has been traditionally popular. However, it is also growing in
popularity in new asset sectors, such as movables and equipment,
because of changes to IAS – which has boosted incentives for
companies to opt for the operating leasing over the finance lease –
as well as the advent of Basel II, and the growing need for a lot
of assets to escape the obsolescence trap.
But analysing and understanding both the rate of growth and the
role of operating leasing on a pan-European level is incredibly
complex and almost impossible, due to the different ways in which
the product is defined and treated in each country.
Furthermore Siemens Financial Services (SFS) maintains that
often the definition of an operating lease is up to personal
interpretation, which, inevitably, makes standardising market
trends and determining the inherent level of operating leasing
incredibly complex.
Defining operating leasing
For the sake of simplicity, operating leasing can either be
defined according to international accounting standards, or
according to whether the asset and lease includes a residual value
risk.
Rod Barthet, director of SFS says this definition is
fundamental. “You need to ask, is this lease with an RV risk, or is
it a truly accounting compliant operating lease? It is never in the
domain of the leasing company to determine whether a lease is an
operating lease. It’s up to the customers’ own auditors.”
International Accounting Standards (IAS) 17 – which determines
the appropriate accounting policies and disclosures to apply in
relation to finance and operating leases – defines an operating
lease as where the lessor recognises its leased assets as fixed on
its balance sheet, and where the lessee considers its assets
off-balance sheet, so lease payments are treated as an operating
expense.
Some lessors in the UK, including SFS, follow the guidelines
under SSAP 21, part of UK Generally Accepted Accounting Principles
(GAAP), which, besides the standard rules on balance sheet
accounting, also takes into consideration the role of RV risk. It
classifies an operating lease as an agreement which puts the risks
and rewards of a leased asset into the hands of the lessor, as
opposed to a finance lease in which the responsibility lies with
the lessee.
Although this classification of operating lease is generally
shared by most markets, the extent of the role that RV plays
differs. In the UK, for example, if the amount paid over the lease
is less than 90 per cent of the value of the asset, due to the
residual value depreciation, then it is treated as an operating
lease under SSAP 21.
“It has to have an RV, but it must be in excess of 10 per
cent,” Barthet says. “For example, if a car is worth £10,000,
but rentals are calculated to total £8,000, because residual value
is £2,000, then it is classified as an operating lease because
payments are less than 90 per cent of the original value of the
asset.”
National Standards
Although each country in the CEE region has a specific leasing
and taxation law, in principal, each market defines operating and
finance lease under IFRS (IAS) principals, according to Fric.
But this generally only applies, however, to the large leasing
companies – which are the main drivers of operating leasing –
because since they are predominantly international groups, they
have to adhere to their own reporting requirements that are bound
by IAS, says Fric.
Fric adds that in the CEE also, residual value risk is one of
the most important components in operating leasing. As a result,
operating leasing is defined both according to whether it carries
RV and also accounting principals.
“It depends on the clients’ requirements and their contract for
how we define an operating lease. The bigger leasing companies in,
say, Austria, can make individual contracts to fit the clients
preferred structure.”
Meanwhile the Belgium market boasts one of the highest
levels – 40 per cent – of operating leasing in Europe after
the UK because of the large number of captive finance companies
that are prepared to take RV, according to Marc De Waele, managing
director at KBC
Lease.
Consequently, De Waele says, operating leasing is generally
attached to assets such as trucks, trailers, cars and real
estate.
Advantages of operating leasing
SFS distinguishes two types of asset classes that lend
themselves to operating leasing. There are those assets, such as
wheeled assets, healthcare equipment, printing presses and LCVs,
which have a high enough value at the end of the lease period so
that they meet or exceeds the residual value, or behavioural
assets, which have the likelihood of being extended or sold off
after the end of the lease period to make profit and cover the RV.
This includes office equipment, computer systems and
photocopiers.
Wheeled assets continue to be the most popular assets to tie
operating leases to throughout Europe. For example, of the 40 UK
leasing SMEs that Leasing Life surveyed in July, 44 per
cent specialise in wheeled assets, 33 per cent in IT and 28 per
cent in non-wheeled assets. Similarly, in Poland and Slovakia, cars
and small commercial cars make up 90 per cent of operating
leasing.
The ‘off-balance sheet’ accounting treatment associated with
operating leasing functions as one of the most obvious advantages
for UK firms wanting to lease equipment, because, as Pickering
says, the “the capital requirements for the lessee is different”.
The treatment can also result in an improved Return on Asset (ROA)
due to a lower asset base.
Operating leasing also suits those lessees who don’t want to own
the asset at the end of the lease period and may want to resell or
remarket their goods, and also ensures that rental costs are
cheaper, because it is based on less than the asset value.
The short-term nature of an operating lease means that in the
heightened pace of technological change, companies do not have to
make huge outlays every two to three years in upgrades.
According to Pickering, the biggest advantage of operating
leasing is in its reflection of the economics of an asset. He said:
“If you don’t want to run some machine or vehicle into the ground
and just want it just for a period to move onto the next model,
then operating leasing fits that. It’s the more efficient use of
resources.”
Public sector
Operating leasing is particularly popular with schools and the
healthcare sector, because not only does it transfer the risk of
the asset onto the lessor – an essential ingredient for the public
sector, which has budgetary constraints and bureaucratic red tape –
but it also allows lessees to escape technological
obsolescence.
Equipment such as MRI scanners, life monitors, diagnostic kits,
imaging, and even private clinics for the healthcare sector, as
well as computers for schools, requires continual upgrades,
monitoring and even reselling or remarketing that only operating
leasing, which also lends itself to ‘one-stop shop solutions’, can
provide.
Commenting on this trend in western Europe in particular, Bruno
Leray, general manager at GE
Commercial Finance, says: “Previously the lifecycle was seven
to 10 years, now it is four to six, therefore the need for renewal
is quicker and that’s why these countries have professionalised
their operating lease markets.”
Impact of IFRS
The IFRS amendments to IAS 17, which stopped lessors being able
to claim capital allowances and hence tax advantages on finance
leases over a period of seven years or more, has seen the long-term
finance lease become more of a simple financing facility and hence
made the operating lease be viewed as a viable
alternative.
Pickering says: “Some deals in some part of the market have
become unattractive because of these tax changes, people are
looking elsewhere, to the operating lease.”
Fric also says that changes to IFRS and Basel II have resulted
in an increase in demand for operating leasing throughout the CEE,
since many of the rules applies to the international leasing
subsidiaries that are dominant in the region. He said: “Under Basel
II banks consider simple financial leasing like a credit, so there
has been a strong trend for operating leasing. We have seen a
doubling in demand because of changes to accountancy practices and
ratings systems applied with banks, not only in car leasing but
also movables, such as machinery and equipment. Clients want to
keep the balance sheet total as small as possible and according to
IAS 17, they now need operating leasing.”
Lease of choice
Sarah Thomson, accountancy academic at Heriot-Watt University in
Edinburgh, surveyed 198 corporate finance directors on ‘The role of
leasing in UK corporate financing decisions’ in 2005 and found
that, as expected, the use of operating leases to acquire vehicles
appears was the most popular among 49 per cent of respondents,
compared to 23 per cent opting for the finance lease. Furthermore,
operating leases also outperformed finance leases in the
acquisition of office equipment, by 29 per cent to 14 per cent, and
both products came out equal in the computer equipment sector. But
in terms of plant and machinery, the asset sector that finance
lease generally dominates, Thomson found that operating leasing had
increased by 3 per cent between 2003 and 2005, while finance lease
had decreased by 3 per cent over the same period.
FurthermoreLombard, the largest UK and European lessor,
attributed the growth in its property, plant and equipment leasing
book to £18.3bn for half-year 2006 to an increase in its operating
lease assets.
And, in Slovakia, operating leasing as a proportion of movable
assets increased by 65 per cent in 2006 on 2005, to represent 7.1
per cent of the €2bn market. Marian Tibensky, head of the Slovakian
Leasing Association says that the market’s outlook for operating
leasing is a growth of over 10 per cent year on year.
But operating leasing still has a long way to go, particularly
in continental Europe, where growth is starting from a very low
base, and according to the FLA, “where the product is very
immature, if not, until recently illegal in some countries”.
Nevertheless, particularly in the UK, as tax and accountancy rules
under the IFRS and IAS and distinctions become blurred between the
definitions, uses and advantages of finance and operating leases,
says Pickering, “in 10 years time, there may not be such a thing as
a finance or operating lease, but just a lease”.
