Accounting Change On Operating Leases To Add $3 Trillion In Debt To Corporate Balance Sheets

From a practical perspective, operating leases are pretty much the same as debt.  They reflect a contractual obligation on the part of one counterparty to make defined stream of cash payments to another over a set period and with an implied interest rate embedded in the payment stream.  In fact, within a bankruptcy context operating leases are treated exactly the same as debt and rank pari passu with the other general unsecured obligations of a business.  That said, accounting rules treat operating leases differently than debt and do not require them to be included as a liability on a company's balance sheet.  That is, until 2019.


As Bloomberg points out this morning, starting in 2019 new accounting rules, called IFRS 16, will force companies to include operating lease commitments as part of their reported debt obligations.  And while the end result will have far-reaching implications, the biggest will be the addition of roughly $3 trillion in debt to corporate balance sheets.


Of course, retail, telecoms, energy and airline companies will be most affected by the new rules.


Leases


 


And here are the largest users of operating leases. 


Leases


 


Of course, some will argue that the accounting rule changes don't alter a company's cash flow profile and are therefore irrelevant.  That said, to the extent interest rates remain low, the present value of future cash payment obligations will undoubtedly serve to drive the pro-forma leverage profiles of some companies through the roof...much as low interest rates have wreaked havoc on pension underfundings over the past several years.









Some companies already spell out the impact of leases on total indebtedness. Air France-KLM's reported net debt is 3.7 billion euros ($3.9 billion) but its lease-adjusted net debt is 11.2 billion euros. The present value of Tesco's operating lease commitments is one and a

half times the size of reported net debt, according to its 2016 annual report.


 


Even so, I doubt this transition will be painless. At the very least, the rule change should give armchair investors, not to mention a company's customers, employees and suppliers, a much better idea of how risky a business is compared to rivals. For some folk, this

will be a nasty surprise. Worries about corporate leverage are already widespread.


 


Besides, companies aren't always as forthcoming as you might hope. Some airlines make debt adjustments for aircraft leases but not for other off-balance sheet rental agreements such as airport buildings. Delta Air Lines Inc. reported $6.1 billion in adjusted net debt at the end of December, including $2 billion in aircraft rent liabilities. Yet the discounted value of all its operating leases is closer to $9 billion, Gadfly estimates.



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