A potentially huge accounting change

The Economist featured a story in this week’s magazine–or as the Brits call it, newspaper–on a proposed accounting change. It was proposed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on August 17, and it focuses on how leases are characterized.

Here’s the short-term version of lease characterization–and I’m playing loosey-goosey with this, too (if you’re an accounting type, feel free to clarify or correct by adding a comment below.) Basically, by having or not having certain characteristics–a bargain purchase option comes to mind–a lease can be characterized as operating or capitalized.  That’s a critical difference, as an operating lease doesn’t show up on the balance sheet, per se, nor does the asset that’s being leased.  A capitalized lease, in contrast, is considered long term debt, with an associated asset on the balance sheet, and that can have huge implications in corporate finance and investing.

The Economist cites a Pricewaterhouse Coopers study that, “found that it would add about 58% to the average company’s interest bearing debt.”  Rent is paid on an operating lease while principal and interest are paid on capitalized leases.  Those two items are found in different places on the financial statements:  rent is part of operating income; principal and interest payments are not.  “On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards.”  Also, that, “since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge.”

Thanks to Dave Whisler, CPA, for pointing out that, “one more consideration is that in many situations companies that in the past had been in compliance with their debt covenants will now be violating them. This means that banks and their borrowers will be in a different world than they are this year. You still have the same benchmark (debt covenant) but you are calculating ratios such as debt to equity using different components than what was used when the loan was originated.”

Here’s an example of one company that would be very affected.  Walgreens (WAG), along with most other retailers, owns none (again, loosey-goosey) of its store buildings, but occupies them with operating leases; thus, there is no debt related to buildings on the company’s balance sheet.

A close look at its SEC 10-Q filing shows that its long-term debt is $2.35 billion (see below; click to enlarge).  That gives it a very modest 13.5% long-term debt to capital ratio.  Its operating leases, however, total $36.4 billion.  A portion of that ($2.2  billion) is due in the next year and is considered a current liability, so long-term debt should be $34.2 billion (36.4 – 2.2) higher.

Complete table below.

Suddenly, a company conservatively positioned–i.e. with low leverage–is outrageously leveraged at 2.08x–or on an equivalent basis, 208%!

Unfortunately, the operating lease information is buried in the notes to the financial statements, which means that one can’t screen for high or low operating leases.  It requires going through each company’s 10Q and searching for the data.

As our newest-minted earner* of the Chartered Financial Analyst† designation, Zach Higgins, pointed out, this shouldn’t be news to the analysts.  They should have looked through to the notes and seen the financial impact.  Zach’s right if the analysts do their jobs, but the same should be able to have been said about options expensing, and yet that produced plenty of softness in the big option issuers.

*  Technically, Zach needs another year of experience before he can be a holder of the coveted designation.

†  Just in case any one from the CFA Institute is trolling the internet looking for degredations of the integrity of the charter, Zach will not be a CFA.  Instead, he will be a holder of the CFA® designation.

One would think that at least the cashflow impact would be nill since the cash effect of the reclassification is zero:  the companies are still going to make the same payment.  In fact, the statement of cash flows will be different.  The statement is divided into three parts:

  • Cash from operating activities
  • Cash from investing activities
  • Cash from financing activities

The cashflow associated with the operating lease is shown as an outflow in the operating section.  A capitalized lease’s cashflow is shown as a cash outflow in the financing section.  The operating section is considered the core of the business, since it represents what the company is set up to do (i.e. operate, sell books or machines or whatever).  The financing and investing sections represent the way the company funds its operations.

So here’s the bottom line.  Reclassifying from operating to capitalized will do the following:

  1. Make operating earnings look better
  2. Make operating cashflow look better; total cashflow will be unchanged
  3. Make a company appear more levered
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