Changes To This Accounting Rule Would Have Massive Repercussions

Nerd alert: this article dives deep into the nature of accounting practices and how a change in rules could drastically affect the capital structures, financing abilities, and value of hundreds of companies and more importantly, could drastically affect the value of your portfolio.

Leasing: the bane of accounting students around the world due to its sheer complexity and variability in standards. However, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working on a proposal that would vastly alter the capital structures of hundreds of companies in the U.S. and significantly affect financial performance.

Capital or Operating

There is a sharp distinction for companies in how they report leases of assets that can affect the total amount of liabilities they have to report on their balance sheet. One kind is simpler to report, an operating lease, which is basically just like paying rent. The company records an expense in each period of rent expense equal to the required payments under the lease agreement.

However, under a capital lease, the company reports the asset, for example an aircraft, on its balance sheet as an asset. However, the company must also recognize the present value of the future lease payments as a liability, increasing the liabilities of the company. Companies leasing assets, known as lessees, do not like capital leases because they require added liabilities, which increases leverage ratios such as the debt-to-equity ratio. However, companies supplying the assets, known as the lessors, prefer capital leases due to the classification of cash flows for their financial statements.

Related: Freeport-McMoRan and Other Mining Picks from Deutsche Bank (CDE, FCX, VALE).

Off-Balance Sheet Liabilities

Airlines are notably cited as abusers of the ability to hide liabilities off the balance sheet by structuring leases as operating leases instead of capital leases. There are four triggers that make a lease a capital lease and an operating lease has to avoid any of the four, which are:

• No transfer of ownership, which is easy to avoid.


• No Bargain-Purchase Option, an option in the contract that allows the lessee to purchase the asset at a price below fair value.


• The lease period must be less than 75 percent of the economic life of the asset, otherwise the lessee is assuming a majority of the risk of the asset and must capitalize it.


• The present value of the lease payments must be less than 90 percent of the fair value of the asset.

Taking airlines as an in example, in 2010, Delta DAL had 22 percent of its nearly 1,000 aircraft financed under operating leases, meaning that these leases were off of the balance sheet.

American Airlines AMR AAMRQ, now owned by U.S. Airways LCC, reported that 25 percent of its nearly 900 aircraft were financed off of its balance sheet. With these planes costing upwards of $1 billion each, these off-balance sheet liabilities could amount to tens or even hundreds of billions of dollars of un-recognized liabilities for companies across the country.

Capital Lease As a Form of Financing

Capital leases are thus a type of financing for companies that supply low, fixed-rate financing to purchase assets for a period without ever having to fully take ownership of the asset. In the practice of accounting for these leases, the company actually incurs lease expenses, depreciation expenses, and interest expenses, which makes tax reporting much more complicated and can cause companies to make mistakes in reporting.

For example, Brinker International EAT and Darden Restaurants DRI are just two of many companies that have had to restate financial statements and revise earnings lower due to miscalculations in accounting for leases.

Further, an entire industry of leasing of long-term assets has sprung up, with many large companies having their own leasing arms and some companies even specializing in lease finance. Captive Leasing Companies, as these subsidiaries are known, are owned wholly by large manufacturers and control the leasing operations of the companies. Independent firms also supply leasing for long-term assets.

Companies such as Caterpillar CAT, Ford F, and IBM IBM all own Captive Leasing Companies who could see serious affects to profits if they are forced to change the way that they report operations to the Securities and Exchange Commission. Independent companies such as Air Lease Corp. AL, Aircastle Limited AYR, and Fly Leasing Corp. FLY are all firms that specialize in aircraft leasing.

Slow Changes

These changes will not happen overnight and have been meticulously written, studied, and rewritten for years as FASB, IASB, and the SEC want the impact of changing the rules to be as minimal as possible.

FASB and IASB will host several roundtables later this year where companies and accounting firms can express hesitations related to the proposed rule changes and it will be some time before the rules take affect. Either way, this is not something to forget about.