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This article first appeared in The Edge Financial Daily, on March 21, 2017.

 

COMPANIES have been on a borrowing binge but you would not always know the full scale of their liabilities by looking at the balance sheet. This makes it hard for investors to compare businesses that fund their activities in different ways. Happily though, that is about to change.

How come? The answer is buried in the notes to financial statements (you know, the ones you do not bother reading). It is here that companies have parked about US$3 trillion (RM13.29 trillion) in operating lease obligations, according to Bloomberg data (1). For non-financial companies, those obligations equate to more than one quarter of their long-term (on-balance sheet) debt (2).  

Operating leases are actually pretty similar to debt. They represent money companies will be obliged to cough up in future to rent things like planes, ships and retail floor space. But right now you will not find them on the balance sheet (3) [see chart — Lease Lenders].

From 2019, this will change. New accounting rules called IFRS 16 (4) will force companies to include operating lease commitments as part of their reported debt and assets (5). Heavy lease users in the retail, telecoms, energy and airline sectors will probably be most affected (6).

The upshot: this is going to make companies appear far more leveraged. Debt will increase compared to equity. At the same time, earnings before interest, taxes, depreciation and amortisation (Ebitda) may increase because leases will be depreciated, not expensed. Retailers can typically expect an Ebitda uplift of more than 40%, PwC found.

The impact on reported liabilities is likely to prove most significant though.

I sympathise if you are tempted to dismiss this is as another dull accounting exercise. Total cash flow will not be affected, and cash is what pays the bills and determines the value of a business. Furthermore, rating agencies and analysts already adjust for leases when assessing credit-worthiness (7).

Some companies already spell out the impact of leases on total indebtedness. Air France-KLM’s reported net debt is €3.7 billion (RM17.61 billion) but its lease-adjusted net debt is €11.2 billion. 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.

But companies are not 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 US$6.1 billion in adjusted net debt at the end of December, including US$2 billion in aircraft rent liabilities. Yet the discounted value of all its operating leases is closer to US$9 billion, according to Bloomberg estimates (8).

Accounting reform can also affect corporate behaviour. When British companies had to start recognising the full liability for defined benefit pensions on financial statements, a lot of those “final salary” plans ended up closed.

It is conceivable therefore that IFRS 16 will affect corporate decisions on whether to rent or purchase an asset. Consider sale and lease-back arrangements. These were once a popular way for companies to get their hands on some cash and a quick chance for executives to make themselves look like geniuses. All of a sudden, return on assets improved.  

Now, if all that rented floor space has to sit on the balance sheet anyway, selling off the corporate silverware might become less attractive.

Another approach may see some companies partly embrace shorter lease terms to minimise the balance sheet liability, according to Ruxandra Haradau-Doser, aviation analyst at Kepler Cheuvreux. Shorter leases are already common in retail, albeit for different reasons. With sales migrating online, retailers want more flexibility to close stores. IFRS 16 could accelerate that.

The accounting changes could also lead to more volatility in financial results, according to James Stamp, a partner at KPMG. Airlines typically take out aircraft leases in US dollars. If the carrier’s domestic currency weakens against the dollar, its liabilities would suddenly increase and it would have to take a currency hit against earnings. Stamp thinks demand for hedging will rise.

Far from being academic, the accounting changes will have an effect in the real world. Some may be profound. — Bloomberg

1) This figure is not discounted. The present value of global lease payments is about US$2.2 trillion, according to an IASB estimate. It compiled data from 2014 annual reports. More than 80% of that total relates to just 1145 companies.
2) Again on an un-discounted basis.
3) Finance leases are different. These are already included on the balance sheet.
4) US companies will apply a new FASB standard that is broadly similar to IFRS 16, albeit not in all respects.
5) If describing something you rent as an “asset” seems odd, remember that a lease is not just a financial obligation, it also represents the right to use that asset.
6) There are exceptions for oil and gas exploration leases.
7) A widely used approximation is to take the annual rental expense and multiply it by seven or eight times.
8) Using the industry’s standard calculation of 7 times annual rental expense (US$1.3 billion for Delta).

 

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