Editor’s Note: Accounting Standards Update 2016-02, which requires companies to record operating lease assets and liabilities on the balance sheet, went into effect for calendar year 2019. The adjustments/treatment of operating leases described below pertain to periods prior to 2019. For periods after 2019, we account for operating leases as explained here.
In a recent report, I detailed the dangers of operating leases as a form of off balance sheet debt. These operating leases are a method of financing that doesn’t appear on the balance sheet. Operating leases only impact GAAP data through a rental expense on the income statement. This is different from capital leases, which increase the assets and liabilities on a company’s balance sheet, imitating the purchase of an asset with debt.
Operating leases are simply a way for companies to use an asset without recording the asset or corresponding liability on the balance sheet. As a result, reported assets and debts are understated, and the company’s returns on assets/capital are inflated compared to the returns of companies that purchase assets or use capital leases.
New Constructs reverses the accounting distortion of operating leases by adjusting the reported financial statements. These adjustments standardize the capital structure of the businesses and allows for apples-to-apples comparison of returns on invested capital (ROICs) across all 3000 companies we cover.
This adjustment is one of the many we make as part our due diligence process on all stocks we cover.
We applaud the Financial Accounting Standards Board’s (FASB) latest proposal to change the way leases are reported. The new rules would make only the shortest-term operating leases exempt from being recorded on the balance sheet. Under the new standards, any lease over twelve months in length would generally be treated the same way a capital lease is treated under the current system: by having the lease’s obligations recorded on the balance sheet as liabilities and the value of the asset recorded as an asset.
The board has recognized that the amount of operating leases on a company’s income statement are often “substantial,” and is going a step further in “proposing disclosures that should enable investors … to understand the amount, timing, and uncertainty of cash flow arising from the leases.”
This new proposal eliminates the vague distinctions of “capital” and “operating” leases and will allow any meaningful lease to be reflected in its true value as a liability on the balance sheet.
Some firms and groups have voiced opposition to this proposal by claiming that it will simply shift demand to short-term leases, allowing firms to record their costs on the income statement and negating any desired effects of the new proposal while increasing credit risk for lenders. In response, FASB has mandated that any lease with the option to extend past 12 months or purchase will also be recorded on the balance sheet.
Allowing companies to hide operating leases and their associated liabilities off of the balance sheet has undermined the quality of financial reporting. Too often, it incentivizes companies to lease assets so they can report artificially lower debt and assets. A look at the numbers reveals how widespread this practice is.
New Constructs found 2,793 companies with off-balance sheet debt totaling nearly $760 billion in 2012 alone. Going back to 1998, we have found over $7.3 trillion in off-balance sheet debt hidden on 33,749 filings. I question the motives of companies fighting against the improved transparency of FASB’s new proposal.
As a member of the FASB’s Investor Advisory Committee, I advise the board on matters, like this one, that can affect the financial view of a firm from an investor’s perspective. The goal here is to make analysis of a company’s true earnings easier
For example, without including its $3.5 billion in operating leases in 2012, Starbucks (SBUX) would report invested capital of $4.3 billion and an ROIC of 34%. However, including the value of these leases brings Starbucks invested capital up to $7.8 billion and its ROIC down to 19%. In addition, those operating leases would increase SBUX’s debt from its reported $550 million to its true $4.2 billion. Investors not currently adjusting for operating leases as we do may be unaware that SBUX has nearly eight times more debt than it reports.
It is refreshing to see the FASB recognizing the distortions and loopholes that have arisen over the years to obscure the whole picture of a company’s leverage and earnings.