When David Page, a partner with Arthur Andersen & Co, addressed the 14th Leasing Digest Conference on Equipment Leasing, he ruefully acknowledged that lease accounting has acquired a bad name in the UK since the collapse of Atlantic Computers and Blackspur Leasing. However, even if the Atlantic business has tarnished the reputation of the accountancy profession, Page quite rightly points out that the demise of leasing companies isn’t a phenomenon of the 1990s. In the early 1980s there were five leasing companies quoted on the London Stock Exchange, and by the time of Atlantic’s downfall, United Leasing, Dataserv, Comcap and IBL had all been acquired.

Guilty of front-loading

Consequently, there are now no publicly-quoted leasing companies. Page believes there is a feature common to the various collapses and it relates to the method adopted for recognising profit. Most were guilty of front-loading income, which means there is little or no income left in later years. So long as these companies were experiencing dramatic growth, the consequences of aggressive income recognition weren’t apparent, but when the growth rate declined, financial performance suffered. Page also believes that the main cause of the difficulties experienced by leasing companies has been accounting for residual values, which involves a great deal of risk because of changing technology. Operators like Atlantic would normally refinance a lease and bear the residual payment which is represented by a final balloon payment to the refinancing bank. But as Page points out, it is important to review periodically the dealer’s residual value commitments against current estimates of realisable values of the equipment and provide for any losses arising. These commitments should be disclosed in financial statements together with the related accounting policy. As regards upgrades or flex options, Page says that there is no particular accounting issue arising so long as the lease documentation makes clear which party is to bear any loss on the disposal of surrendered equipment, and losses normally arise if the lessor has adopted an aggressive residual position or an event in the market has led to a deterioration in residuals. Page says that from press articles, it appears that Atlantic salesmen were abusing this system. It is alleged that when customers realised they had to bear the cost of obsolete kit, the salesmen loaded high rentals onto the new equipment contract towards the end of the new lease, usually after the flex point. As customer requirements were always changing, it was argued that upgrades would always be required and the contract would never go beyond the flex point. Consequently, the higher rentals would never be reached and losses could be rolled forward indefinitely. Page contends that these problems are less the result of a theoretically flawed accounting practice than an imprudent application of sound accounting policies – although layfolk may wonder if an accounting practice that permits such imprudence is not theoretically flawed.

By Janice McGinn

That is how the accountant interprets events at Atlantic, and James Watters, a partner in Stephenson Harwood, went on to present the legal view. He defines the computer lessor as a broker with a clear objective – to get the maximum amount of money in the shortest time with the minimum of risk. He says that the meaning of Atlantic’s flex agreement was extremely obscure, but the real problem arose from the walk which enabled Atlantic to trade on the good covenant of the lessee to raise a sum equal to a couple of years’ rent. However, something went wrong and Watters says we are now in a fascinating situation where lawyers are generating large legal fees trying to ascertain who has rights of possession, who has liability, and whether head lessors may terminate leases. He suggests that a framework for future computer leasing must meet several criteria. It must not give rise to any doubts over the entitlement of the owner to full tax benefits, and that must be taken into consideration when pricing th

e deal. Secondly, the risk of non-performance of any agreements by brokers to provide walks and flexes must be carried by the user. Thirdly, he believes that it should not be necessary for the financier to be caught up in problems arising from any administration of the broker, and perhaps most important, the lessee should clearly understand the implications of any arangements to which he is party. The components of such a framework ought to include a straightforward direct lease between the financier and user for a period of years to which the lessee is willing to be committed to paying rent. This is coupled with an acknowledgement by the lessee to the lessor that if there are any agreements preceding or subsequent to the lease – to which the lessor is not party, then the provisions of the lease prevail. Next, there should be a management agreement between the lessor and broker covering terms under which the broker will be permitted to arrange early termination of the lease and arrangements under which the residual value will be recaptured and/or underwritten by the broker. And lastly, financiers should be prepared to underwrite enough of the residual value of a machine to ensure that the lease is off balance sheet. Lessees seem to occupy a secondary position in the world of lawyers and accountants, but Bernard Jones, an ex-IBMer and now senior analyst with Gartner Group UK Ltd, attempted to speak for users and describe their reactions after Atlantic. While acknowledging that generalisations are dangerous, Jones says that the lessee community has been characterised by a deep-seated ignorance of the true significance of contracts into which it has been freely prepared to enter.

Something for nothing

He believes this ignorance was manifest in the questions raised in the immediate aftermath of Atlantic, and in the amount that has been taken on trust. All too often, there was an implied expectation on the part of the user of something for nothing, and that was not discouraged by unscrupulous operators. Consequently, users are reappraising financing choices and changing their perception of leasing as an option. Lessee behaviour, according to Jones, falls into one of four categories. Some users are rejecting leasing as a financing alternative and adopting the baby and bathwater approach. Others are playing safe and handing over their business to vendor-captive companies in the belief that this assures them of satisfactory contractual terms and conditions coupled with attractive pricing. However, they are overlooking the vendor’s motivation and the fact that IBM now writes leases on 65% of new leased mainframes, that Fujitsu via ICL will soon enter the leasing market, that DEC is about to embark on a major expansion, and that both Amdahl and Hitachi are involved in operating leases. The third group is continuing to use operating leases, but are subjecting proposals and proposers to a much more rigorous scrutiny than was formerly the case. Jones reckons there is a also fourth group, the innocents that continue to ignore precedent and carry on as before. He believes that the interests of information technology user can be best served by an ongoing, competitive leasing industry. That can only be achieved if both lessors and lessees have a structured negotiating approach, and each can comprehend the other’s motivation and objectives.