Consequences of the Capitalisation of Operating Leases

Economic consequences of the capitalisation of operating leases:

1) Operating lease capitalisation is likely to have a significant impact on the company's performance ratios. When the leases are capitalised, it has to be reflected in a balance sheet by creating additional asset and liability. One of the main consequence of this is an increase in debts ratios (e.g. gearing ratios) and, thus, in the reported leverage. This can lead to considerable changes in company's risk and loan assessment and/or credit rating. In order to measure company's risk, analysts have to take into the consideration various factors and review different performance ratios. However, usually they firstly look at a company's leverage (asset-based ratios, gearing ratios). The higher the gearing ratio is, the greater the chance that the company can be insolvent, when its debts are due, is.

Companies with a low-income elasticity, such as electric utilities companies, can carry high debt ratios, and it will not alarm the creditors to a considerable extent. However, Tesco, as a retail company which heavily rely on operating leases, is likely to be affacted by capitalization of their operating leases.

According to the study by Kostolansky and Stanko (2011), who analyzed the potential impact of the capitalization of the leases proposed by the joint FASB/IASB lease project (2010), companies of the "Retail Trade" group would suffer from a potential increase in total debt to total asset of 14.77%.

Creditors also analyze companies' debt ratios, whether to decide on granting a credit or to determine the interest rate. Commonly, they seek for the companies with higher debt ratio that would ensure a greater 'safety of margin' for them.

For Tesco, the difference between pre-capitalisation and post-capitalisation gearing ratio is +45,13% (if calculated using ILW methodology). Such an impact of lease capitalisation is likely to lead to the consequences described above.

It should also be noted that capitalisation of operating leases can have signification economic consequences for the whole industry. Nowadays, companies which rely primarily on the operating leases are likely to find themselves in a better financial position comparing to their competitors who own the majority of their assets. Nevertheless, capitalization of operating lease can change the situation diametrically. Companies who continue to rely on leasing could be in a less favorable financial positions comparing to their counterparts. (Noland, 2006). This can make leasing less attractive for companies and they can choose purchasing assets over their leasing.

In the cases, when purchase is not available (or is an even less attractive option), the leasing agreements are likely to be modified in two possible ways: the leasing terms can be shorten; or making