The poor airlines—I suppose it’s just not allowed to let them revel in their success. Everything seemed to be going their way. Reduced competition and low oil prices had combined to drive profits and stock prices to all time highs. But lest they get too comfortable, the US accounting standards board, FASB, decided it was time to knock them back down a few pegs. See, last week FASB finalized a change in how operating leases would be accounted for under US GAAP. Currently, airlines use operating leases as one way to finance the acquisition of aircraft, and under the current standard, operating leases are not recorded as liabilities on a company’s balance sheet. Instead, their disclosure is relegated to the footnotes where those untrained may not be predisposed to look. Under the new standard, any company incurring an operating lease obligation will be required to report that on its balance sheet.
This will not be a big news event for trained accountants or financial analysts. But for those investing for their own account, it may highlight a potential risk in the current lease accounting reporting standard, and serves as a reminder not to ignore the footnotes.
What are the implications? Say I was analysing the big three airlines in the US: United, American and Delta. If I wanted to assess their level of financial stability, I would start by calculating their indebtedness and their ability to repay such indebtedness. The leverage ratio of “Net Debt / EBITDA” is a common measure of liquidity used by banks and investors alike. Essentially, it estimates the number of years it will take for the company to pay off its obligations. Typically a leverage ratio higher than 3x is seen as riskier than average, though any assessment of financial stability has to include an evaluation of the strength and resilience of said business.
Looking at the airlines, under the current reporting standards Net Debt/EBITDA stood at less than 1x for both Delta and United, and at 1.6x for American. If I include their operating leases (and make an adjustment to EBITDA to exclude rent expense, an adjustment that bankers typically make when lending to companies with high levels of operating leases), then those ratios climb to well above 2x for American and United (almost 3x), and just under 2x for Delta. Any investor sitting at home contemplating buying the stock of one of these companies needs to appreciate the increased risk that represents.
But the airline industry is not the only industry affected. Indeed, the most common use of operating leases is for real estate in the retail industry. Looking at a broad range of retailers in the US, the new accounting directive will have a massive impact on the appearance of many financial statements. On the surface, mall retailers the Gap, Abercrombie & Fitch, American Eagle Outfitters, Urban Outfitters, The Children’s Place and Finish Line (shoe retailer) all appear to be financially rock solid with no net debt. But include operating leases and most of these companies’ financial leverage jumps to over 2x! Budget priced retailer Kohl’s has debt on its balance sheet, but its leverage ratio balloons from 1.3x to 3.2x—that’s getting into risky territory.
I don’t imagine that the new disclosure rules will dramatically tip the balance of any single company’s credit worthiness, but more transparency is always better. If you are thinking of investing in a retailer, or airline, or other company that leases real estate or large volumes of equipment, be aware of how lease accounting works and protect yourself from getting blindsided.
11 thoughts on “Devil in the Lease Accounting Details”
You Bristelmouth folk are excelling yourselves at the moment.
It’s an excellent little lesson for us all on leases Kevin. And quite rightly the retail industry is where it is a bit (understatement) of an undisclosed (or perhaps more correctly ‘hidden inside the notes’) liability that needs to be more widely exposed to investors.
I recently was involved in a retail public company which ‘changed hands’ with the hidden driving motives in selling being the retail leases which were very very large and they went on for 5 plus years. Of course one asks why the new buyers purchased, and you would like to think they did a due diligence?
Well that is a very good question that the Board of the company were not able to answer, and which ASIC did not deign themselves to bother investigating.
So Kevin revealing the leases on the balance sheet is a great development, and you have explained it well.
Pretty crazy that non-cancellable long-term lease commitments have been allowed to stay off-balance sheet for this long, especially as operating leases can be quite expensive forms of debt.
Have a quick look at how much they were with Dick Smith at 30th June 2015?
Yes, no wonder they have shut up shop.
It does show how accounting standards are slowly catching up with one of their chief jobs which is to accurately convey a financial picture of the true state of a business. I don’t hold my breath that the CPA’s are at the forefront of this with their CEO too busy spending their money promoting his television programs interviewing the likes of Tim Costello. How far have the CPA organisation moved from their reason for being!!!
So, you think “untrained” investors are calculating EBITDAR but NOT reading the Notes? You think “untrained” investors are the marginal buyers/price setters for airlines and retailers? Really?
I’m not sure we made that claim, although I’m certain many investors don’t read the notes. Just highlighting an issue less experienced investors might miss, many of whom read our blog. Shouldn’t cause harm to anyone and might help some. But you’re right, it should mostly be in the price already.
Well that’s a great question Mr Skeptical so perhaps you could answer why ‘trained’ investors, such as say Macquarie or Goldman Sachs, invested a lot of their investors money in a retail company like Dick Smith Holdings, while an investment group like Forager didn’t and gave a pretty good (and understandable) explanation to we mere mortal ‘untrained’ investors as to why not.
You see I have big question marks over these big investment banks and other large investment groups full of ‘trained’ investors because all too often they have other motives and reasons for making their ‘trained’ investment decisions.
I prefer the articles, and advice, of groups like Forager because they treat the ‘untrained’ investor with a bit of respect and explain why a business or company is a good or bad investment, or why the inclusion of say operational leases in the notes rather than in the balance sheet as a liability is not such a good thing.
I would suggest your question Mr Skeptical is a cameo of the mindset that looks so disparagingly on value investing and the ‘Buffett’ approach.
I’m sure appreciative of the Foragers reading the notes and explain why they didn’t invest in say Dick Smith a Holdings while other more ‘trained’ investors read the notes and did advise their clients to invest. The difference being one group explained it to the great ‘untrained’ out there, the other just relied upon their ‘trained’ reputation to say ‘just trust us we know what’s best’. The Dick Smirh Holdings episode revealed a heck of a lot to me about ‘trained’ and ‘untrained’ investors.
There is always the concept of risk to any investment. This post is highly technical but certainly helpful. Thanks for sharing.
Probably a stupid question, but why is ANYTHING allowed to be “Off Balance Sheet”?
Not a silly question at all but it’s not quite so straight forward. If a company has a mobile phone contract, should that be on balance sheet? What about commitments to pay staff? I’m not even convinced that this particular rule change makes sense (we already had rules to work out when an operating lease was actually a finance lease, perhaps these just needed to be tweaked so any lease longer than 5 years went on balance sheet but shorter-term ones did not?). We’re drifting further and further down the path of accountants attempting to do an analyst’s job, and it is creating as much confusion as clarity.
Another part of the general craziness is requirement for straight lining of lease revenue for property owners. So unhelpful that the industry now looks to a cash measure (FFO) rather than accounting profit to measure profitability.
I don’t think so Steve.
I think more transparency on disclosing the actual assets and more importantly liabilities of a company is critical. And above all it needs to be in a clear and understandable format.
One of the big lessons from the Enron period is the way the accounting definitions of debt and equity and liabilities were gamed to effectively disguise the true financial state of a company. I would suggest smarty pants accountants, MBA’s and management consultants of the likes of Arthur Anderson (who no longer exist) with and many current contenders of their ilk being responsible.
All too often many liabilities (with operating leases being a classic example) are left out of the obvious view in the financial statements by being hidden in notes that often defy clear understanding.
That’s why the Dick Smith fiasco is a classic example of a basic failure of accounting standards. They will say the $264m or so of lease liabilities did not need to be shown on the balance sheet as it was a going concern or not needed by accounting standards, but thats just the sort of mumbo jumbo to prevent them disclosing what should have been clearly shown.
Annual reports and financial statements are to be written to be understood for the average person not just for analysts and other financial ‘experts’ with the professional gatekeepers (like accountants and lawyers especially) being the worst offenders who use their expertise to often game the system to disguise the true state of the company for their paying client.
So, sorry to disagree with you Steve, but all liabilities should be clearly shown on the balance sheet.