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Say hi to $3tn in debt you've forgotten

Opinion

Companies have been on a borrowing binge but you wouldn't always know the full scale of their liabilities by looking at the balance sheet. This makes it hard for investors to compare businesses that fund their activities in different ways. Happily though, that's about to change.

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File picture: James White

How come? The answer is buried in the notes to financial statements (you know, the ones you don't bother reading). It's here that companies have parked about $3 trillion in operating lease obligations, according to Bloomberg data.  For non-financial companies, those obligations equate to more than one quarter of their long-term (on-balance sheet) debt.  

Operating leases are actually pretty similar to debt. They represent money companies will be obliged to cough up in future to rent things like planes, ships and retail floor space. But right now you won't find them on the balance sheet.

From 2019, this will change. New accounting rules called IFRS 16 will force companies to include operating lease commitments as part of their reported debt and assets. Heavy lease users in the retail, telecoms, energy and airline sectors will probably be most affected.

The upshot: this is going to make companies appear far more leveraged. Debt will increase compared to equity. At the same time, earnings before interest, taxation, depreciation and amortization may increase because leases will be depreciated, not expensed. Retailers can typically expect an earnings before interest, tax, depreciation and amortisation uplift of more than 40 percent, PwC found.

The impact on reported liabilities is likely to prove most significant though.

I sympathise if you're tempted to dismiss this is as another dull accounting exercise. Total cash flow won't be affected, and cash is what pays the bills and determines the value of a business. Furthermore, rating agencies and analysts already adjust for leases when assessing credit-worthiness.  

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 Generation 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.

Not forthcoming

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 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.

Importantly, there's precedent for seemingly cosmetic accounting changes to impact valuation. Last year British aircraft engine maker Rolls-Royce Plc said it would report lower profit under a separate new accounting standard (IFRS 15). Its shares fell even though it stressed that cash flow would stay the same.

Accounting reform can also affect corporate behaviour. When British companies had to start recognising the full liability for defined benefit pensions on financial statements, a lot of those "final salary" plans ended up closed.

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.  

Read also: 'Hooked on debt'

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 US 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.

Far from being academic, the accounting changes will have an effect in the real world. Some may be profound.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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