- A big change in lease accounting rules effective Jan. 1 requires companies to record operating leases on their balance sheets.
- Operating leases include everything a company rents to run its business, from office space, equipment, factories to planes and cars.
- The accounting change will result in an increase in company leverage, a key measure when evaluating a company’s risk.
A new corporate accounting rule is about to pull an estimated $3 trillion out of the shadows.
Starting this year, companies are required to record the cost of renting assets used in their operations, such as office space, equipment, planes and cars, on their balance sheets rather than bury that expense in the footnotes of their financial statements, thanks to a new accounting standard now in effect.
The result will be trillions of dollars added to liabilities on their books. Until now, only leases that led to the purchase of the asset were accounted for in this manner. The change, by the Financial Accounting Standards Board, is supposed to make it easier for investors to evaluate a company’s financial obligations.
Sheri Wyatt, a partner at accounting firm PricewaterhouseCoopers, said “It’s going to affect all companies’ leverage. They will have more liabilities on their books than they had previously.”
Morgan Stanley expects the consumer discretionary sector to experience the largest increase in debt because of this change, and it estimates the leverage ratio for the retail sector to grow to 3.4 times from 1.2 times.
U.S. public companies are committed to a total of $3 trillion in operating leases, according to International Accounting Standards Board. Companies with large amounts of operating leases include retailers and restaurants that lease properties and airlines and shipping companies that lease airplanes, cars and ships.
It may force investors, including quantitative funds, to change the way they measure certain financial criteria they use in making their investment decisions. Leverage — measured in the ratios of debt to earnings or debt to equity — is a fundamental number used when evaluating a company’s risk.
Analysts and sophisticated investors hadn’t really ignored the large amounts of lease obligations when calculating debt ratios. For many years, they have been capitalizing leases by multiplying the annual rent expense by 8 times to get the estimated value of the remaining lease payments. However, the numbers companies now have to put on their balance sheets may look very different than those estimates.
“I do think people will have to adapt to new metrics – and they may be surprised. The liabilities and assets that companies report may look very different from the ad hoc estimates that people have used in the past,” Todd Castagno, equity strategist at Morgan Stanley, told CNBC.
“Those very common metrics that people look at to value equities, to look at performance, to screen for high quality stocks, all those ratios are going to change,” Castagno said.
Quant fund surprises
The change in company leverage will directly affect some quantitative funds that use leverage as a screen.
For example, the MSCI Quality index uses debt to equity as one of the metrics to rank companies. If a company’s debt to equity ratio changes significantly due to the new accounting standard, it will get screened out of the index.
“You might have different companies moving in and out of what you define as quality depending on how these ratios change,” Castagno said.
To be sure, the additional liabilities on the balance sheets shouldn’t have an effect on company credit ratings as they had already been taken into account.
“We don’t expect a significant rating impact,” said Kevyn Dillow, accounting analyst at Moody’s Investors Service. “The credit quality is not changing. Moody’s estimate of a lease obligation is pretty precise in that we calculate a present value based on company’s disclosures.”
Data vendor inconsistencies
To add to the complexity, some data vendors haven’t incorporated lease liabilities into companies’ total debt amounts, and won’t in the future. Depending on what platform investors use, they will get very different numbers.
For example, Refinitiv will not treat operating leases as debt for U.S. companies, only as non-debt liabilities on the balance sheet, to “allow clear comparability of reports across companies, markets and accounting standards,” a spokesperson told CNBC. It will only add the leases liabilities to debt for companies filing under International Financial Reporting Standards, mostly in the European Union, Asia and South America.
Bloomberg Terminal is already incorporating lease liabilities in company debt.
FactSet told CNBC that it has not updated the data for early adopters yet but will capture the operating leases as part of the debt in the next reporting season.
“Some of the data vendors are adjusting and some of them aren’t. Depending on what data vendor you use, you are going to get very different metrics. I think people are concerned with that,” Castagno said.