Question

Explain the reason why, under the former accounting standard, reporting entities’ ‘off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet

Answer 1

Step 1

Understanding Off-Balance Sheet Financing

Off-balance sheet (OBS) financing is an accounting practice whereby a company does not include a liability on its balance sheet. It is used to impact a company’s level of debt and liability. The practice has been denigrated by some since it was exposed as a key strategy of the ill-fated energy giant Enron

Step 2

Examples

Common forms of off-balance-sheet financing include operating leases and partnerships. Operating leases have been widely used, although accounting rules have been tightened to lessen the use.A company can rent or lease a piece of equipment and then buy the equipment at the end of the lease period for a minimal amount of money, or it can buy the equipment outright.

In both cases, a company will eventually own the equipment or building. If the company chooses an operating lease, the company records only the rental expense for the equipment and does not include the asset on the balance sheet. If the company buys the equipment or building, the company records the asset (the equipment) and the liability (the purchase price). By using the operating lease, the company records only the rental expense, which is significantly less than the entire purchase price and results in a cleaner balance sheet.

Partnerships are another common OBS financing item, and Enron hid its liabilities by creating partnerships. When a company engages in a partnership, even if the company has a controlling interest, it does not have to show the partnership’s liabilities on its balance sheet, again, resulting in a cleaner balance sheet.

These two examples of OBS financing arrangements illustrate why companies might use OBS to reduce their liabilities on the balance sheet to seem more appealing to investors. However, the problem that investors encounter when analyzing a company’s financial statements is that many of these OBS financing agreements are not required to be disclosed, or they have partial disclosures. These disclosures do not adequately reflect the company’s total debt. Even more perplexing is that these financing arrangements are allowable under current accounting rules, although some rules govern how each can be used. Because of the lack of full disclosure, investors must determine the worthiness of the reported statements prior to investing by understanding any OBS arrangements.

step 3

Under the former accounting standard, reporting entities’ ‘off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet

It can be described as follows:

Leasing is a common form of finance for many businesses, especially in sectors like the airline industry, retail, and shipping. Currently, listed companies around the world have around US$3.3 trillion worth of leases. Under current accounting requirements, over 85% of these leases are labeled as “operating leases” and are not recorded on the balance sheet.

Despite being off-balance sheet, there can be no doubt that operating leases create real liabilities. During the financial crisis, some major retail chains went bankrupt because they were unable to adjust quickly to the new economic reality. They had significant long-term operating lease commitments on their stores and yet had deceptively lean balance sheets. In fact, their off-balance sheet lease liabilities were up to 66 times greater than their reported debt. Clearly, the accounting does not reflect economic reality.

To compensate for this “missing information”, many investors use various techniques to add operating leases back onto the balance sheet. However these adjustments are often rough calculations, which may be way off the mark.

Moreover, not all investors are able to do this “add-back” and the prevalence of operating leases indicates that companies are aware of that. In some cases companies go to great pains to structure their lease obligations so that they remain off-balance sheet, probably to look better in the eyes of the unwitting investor.

Finally, the current accounting for leases leads to a lack of comparability. An airline that leases most of its airplane fleet looks very different from its competitor that borrows to buy most of its fleet, even when in reality their financing obligations may be very similar. There is no level playing field between these companies.

To address these problems, the International Accounting Standards Board, which sets the IFRS Standards for financial reporting around the world, has issued a new standard on lease accounting, IFRS 16.

When IFRS 16 becomes effective in 2019, it will result in a substantial change to many companies’ balance sheets. All leases will be recognized as assets and liabilities by lessees, better reflecting the underlying economics.

This change is expected to affect roughly half of all listed companies and will not be popular with everyone. Accounting changes are often controversial and can be met with warnings of adverse economic effects, defaults on debt covenants, and costs of system changes. The IASB has looked at all these possible risks very carefully and has concluded that the risks and costs are manageable.

First of all, IFRS 16 will not put the leasing industry out of business. Leases will remain attractive as a flexible source of finance. It will remain appealing to companies to lease assets so that they do not bear the risks of owning them. While the cosmetic accounting benefits of leasing will disappear, the real business benefits of leasing will not change as a result of the new standard.

Secondly, we think it highly unlikely that the improved visibility of lease obligations will lead to significant effects in terms of the cost of borrowing and debt covenants. The majority of credit providers and rating agencies already take lease obligations into account when evaluating a company’s ability to pay its bills, albeit often in an imprecise manner. Moreover, many debt covenants are unaffected by changes in accounting requirements.

We do not deny that there will be costs involved in updating systems to implement IFRS 16. But we have done our best to keep these costs to a minimum. For example, we are not requiring companies to put short term and small ticket leases on the balance sheet. This should be especially beneficial for smaller companies.

In sum, we expect the benefits of IFRS 16 to greatly outweigh its costs. The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management. IFRS 16 will lead to improved capital allocation, which should be beneficial for economic growth.