Coming To A Balance Sheet Near You—-$2 Trillion In Debt Camouflaged As Operating Leases

By Michael Rapoport at Wall Street Journal

Some of America’s best-known companies—names such as AT&T Inc., CVS Health Corp. and Delta Air Lines Inc. —likely will soon have to effectively boost the debt they report on their balance sheets by tens of billions of dollars. The total possible impact for all companies: as much as $2 trillion.

Within a few years, companies may have to add to their books the cost of many leases for real estate, aircraft and other items that aren’t already carried there. U.S. rule makers are set to vote Wednesday on whether to approve in principle long-awaited new rules requiring companies to make that addition, though the move wouldn’t take effect until at least 2018.

If approved, as many observers expect, that change could dramatically boost the reported leverage for retailers, restaurant chains, airlines, package-delivery companies and other companies that use leases heavily. Companies must already disclose their lease obligations, but it is done in the footnotes to their financial statements; they aren’t included in the balance-sheet numbers to which investors pay the most attention.

The proposed move by the Financial Accounting Standards Board could help investors more clearly see the true health of companies that owe a lot of money through lease commitments but currently don’t have to reflect those commitments in their balance-sheet numbers, said FASB Chairman Russell Golden. It “will give investors, lenders and others a more accurate picture of the financial condition of the companies to which they provide capital.”

The change won’t create any new obligations for companies, and it isn’t expected to drastically change companies’ earnings or book value. But it could change some financial ratios, such as return on assets. That is because companies will be adding assets to their balance sheets as well as obligations to reflect the impact of the leases. As assets rise, the return as a percentage of those assets would decline.

The proposed rules have been in the works for a decade, and are “very much needed,” said J. Edward Ketz, an associate professor of accounting at Penn State University. Companies have often structured the terms of their leases to enable them to keep from officially counting many leases on their books, regulators and critics have said.

Ratings firms and investors who closely watch balance sheets have long adjusted their reading of corporate numbers to take into account companies’ off-the-books lease obligations. But the average small investor could be in for a surprise when companies start officially counting billions of dollars in leases on their balance sheet, Mr. Ketz said.

“You have sophisticated people, knowledgeable people in the area who have been doing it. The small investors do not,” he said.

AT&T had $31 billion in operating-lease obligations—those not currently carried on the balance sheet—as of the end of 2014, according to its latest annual report. Adding those obligations to the balance sheet would significantly increase its liabilities; the company has long-term debt of $76 billion.

An AT&T spokesman noted the company’s leases are already disclosed in its annual report’s footnotes, and he said the new rule would simply “change the presentation of this information without giving investors and analysts significant new information beyond what we already provide.”

CVS , which leases real estate for its thousands of pharmacies, had $27.3 billion in operating-lease obligations as of the end of 2014, compared with $11.7 billion in long-term debt. Delta, which leases aircraft, had $12.7 billion, compared with $8.6 billion in long-term debt.

A CVS spokeswoman said that while the new rule could affect a company’s financial statements, “it does not affect a company’s creditworthiness or underlying cash flow.” Delta didn’t have any immediate comment.

AT&T and Delta have criticized the lease-accounting proposal in comment letters to the FASB in the past, and the FASB has faced resistance from others over lease accounting as well. In 2012, the U.S. Chamber of Commerce and other business groups sponsored a study contending that proposed lease-accounting changes could lead to major job losses.

Any time the balance sheet is being changed so much, “there’s going to be some knock-on economic effects,” said Tom Quaadman of the Chamber’s Center for Capital Markets Competitiveness.

Bringing leases onto corporate balance sheets could increase liabilities of U.S. public companies by about $1.5 trillion, according to the Center. IHS Global Insight estimated in a 2011 study conducted for the Equipment Leasing & Finance Foundation that the number could be $2 trillion.

But Mr. Quaadman and other critics say the FASB has been responsive to their concerns, and has scrapped other proposed changes to lease accounting that would have had additional effects. Compared with its initial proposals, the anticipated final rule is “much improved for the industry from where it was,” said Ralph Petta, chief operating officer of the Equipment Leasing and Finance Association, a trade group.

One other issue some critics fear: Adding the lease obligations could trigger violations of debt covenants. But the FASB notes the long lead time until the new rule would take effect means it is likely that many such covenants will mature or be updated before it becomes an issue. And technically, the FASB says, leases will be considered “operating obligations” rather than debt.

The effort to overhaul lease-accounting rules dates to 2005, when the Securities and Exchange Commission called on the FASB to do so. The rules haven’t had a significant revamp since 1976.

The process has gone on long enough for David Tweedie —former chairman of the International Accounting Standards Board, the FASB’s global counterpart—to quip that before he dies, he wants to fly in a plane that is carried on its airline’s balance sheet.

Source: Coming to a Balance Sheet Near You: $2 Trillion in Leases – Wall Street Journal