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.
And here are the largest users of operating 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.
Meanwhile, the biggest impact of the accounting change may be the mere removal of yet another tool that management teams use to ‘game’ their financial statements.
It’s 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. Buying big ticket assets, rather than leasing, is also cheaper now because of low interest rates.
Another approach may see some companies partly embrace shorter lease terms to minimize 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 U.S. 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.
And you thought things couldn’t get much worse for retailers…