New Accounting Rule Could Shock Balance Sheets

 

Takeaway

  • New rule targets abuse of operating leases — but such abuses may be overrated.
  • Investors will be able to compare companies more easily but will lose other financial information because operating and capital leases will be grouped together.
  • Companies should start now to review and reclassify their leases.

Imagine waking up tomorrow and finding out that you’re deeper in debt than you thought you were. That’s a prospect that many American corporations could face when a new accounting rule is finalized as soon as this fall, according to two faculty members at the McCombs School of Business.

The rule, Proposed Accounting Standards Update 2013-270 from the Financial Accounting Standards Board (FASB), aims to curb abuses of corporate operating leases. Critics charge that companies use these leases to hide debts. Indeed, the rule change could add $1.5 trillion in debt to the books of public companies overnight, estimates the U.S. Chamber of Commerce. That could force many to renegotiate the terms of their bank loans, which limit the amount of overall debt borrowers can carry, while risking extra fees and higher interest rates.

“You’re going to shock the balance sheets of companies all over,” says McCombs accounting lecturer Jeff Johanns, a former partner with accounting firm PricewaterhouseCoopers. “Overnight, many of the debt-to-equity ratios embedded in loan agreements will be violated.”

The rule is supposed to provide more information to investors, says Judson Caskey, former assistant professor of accounting at McCombs, now on faculty at UCLA. But as written, it could actually deprive them of critical information about how companies are using leases to begin with. What’s more, his research casts doubt on whether widespread abuse of operating leases actually exists.

Do Leases Hide Debt?

Corporations use operating leases for everything from airplanes to storefronts in shopping malls. What makes them controversial, says Johanns, is that they can be a sneaky tool for a company to keep debt off its books — which makes it look healthier to both investors and lenders.

Here’s how: Over a lease of several years, a firm might pay almost as much in rent as if it were buying the equipment outright. If it projects that total to be at least 90 percent of the equipment’s fair value (or meets one of three other tests), the company has to call it a capital lease. It treats the cumulative payments like a loan and adds them to its balance sheet as debt.

But if payments add up to less than 90 percent, the contract is dubbed an operating lease. It can stay off the books, and — voilà! — the company appears to have less debt.

Chart illustrating different types of leases

Johanns has seen his share of leases in which payments fell just below that magic number. “The lessor, lessee, and the bank all worked together to structure these things to keep them off the balance sheet,” he says.

The new rule would eliminate such sleight-of-hand. It would force most leases longer than 12 months onto companies’ books, adding them as debt. Investors, reasons FASB, could then compare such firms more easily with others that had few or no operating leases.

“The lack of comparability between companies is what the rule makers are trying to overcome,” says Johanns. “They’re saying that the true financial position of any company is better reflected if all the debt is on the books.”

Findings Don’t Support the Charge

But Caskey questions the case for the proposed rule. Rather than using operating leases to conceal their debts, most companies he studied have sound business reasons to lease instead of buy.

His research, conducted with N. Bugra Ozel of UCLA, looks at an industry that’s heavily weighted with operating leases: commercial aviation. At least 61 percent of the planes used by 142 airlines from 1990 to 2012 were leased, according to quarterly filings with the Bureau of Transportation Statistics.

Their findings suggest that a company’s chief aim is not to classify assets as operating leases for shady accounting purposes. Rather, it’s to classify them as “true leases” under a different code: bankruptcy. True leases give lessors protections they don’t have with a loan or a secured interest — like being able to repossess property quickly instead of having it tied up in a bankruptcy case. Such protection, notes Caskey, “makes people more willing to provide financing” to a company too risky for traditional loans.

His analysis of the filings found significant correlations between high rates of leasing and financial risk. Financiers would rather lease than sell planes to a risky airline, explains Caskey, because “with a true lease, the lessor takes it back, repaints it with a different logo, and leases it to somebody else. They do not need to wait for a bankruptcy settlement.”

In contrast, he found no evidence that airlines were using leases to hide debts from investors. After adjusting for factors like size and risk, leasing levels of public companies were comparable to those of private companies, even though public companies had stronger incentives to hide debts. Nor did leases spike before new offerings of stocks or bonds, when a firm might be looking to trim debt from its balance sheet.

Besides, investors already have access to a company’s lease numbers under current accounting rules, notes Caskey. “They’re hiding in plain sight in the sense that companies do have to disclose the lease payments in the notes to their financial statements,” he says, “and banks and ratings agencies already consider them when assessing companies’ leverage.”            

Those numbers can provide valuable information about true leases because they’re normally accounted for as operating leases. “If you want to see an indicator of a company’s financial risk, if it has limited access to traditional loans and must take true leases, you might want to know that,” Caskey says. “It’s something you can’t get from the balance sheet.”

Investors would actually lose that information under the proposed rule because operating leases would be lumped in with capital leases, which the bankruptcy code typically classifies as secured interests. Caskey would like to see FASB amend the rule, requiring companies to add a note about which leases meet the old operating lease criteria.

Although he has reservations about the new rule, he agrees with Johanns that after an initial shock, corporations will adapt. Many will have to renegotiate loans, but a recent study found the average bank loan gets renegotiated five times, or every nine months. “Even if they don’t change the standard, the loans out there are going to get renegotiated anyway.” Caskey says.

What benefits will the economy get in return for those costs? That’s debatable, according to Caskey. “I personally think the rule is kind of unnecessary,” he says.

Johanns expects the transition to take three years, but he recommends preparing for it now. “Companies should begin the process of identifying all their leasing arrangements over the entire country,” he says. “Separate those that are clearly small, month-to-month leases and set them aside. For all remaining leases, they should begin a process of going through every lease and identifying which ones need to be capitalized.” 

 

Faculty in this Article

Jeff Johanns

Jeff Johanns is an accounting lecturer at the McCombs School of Business. He is a former U.S. Assurance Risk Management Leader...

Jeff Johanns teaches in the Texas Executive Education program, featuring open enrollment, custom and certificate classes for executives and organization teams.

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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