Today we pivot back to financial reporting, and the impending new rule on accounting for lease expenses. That rule is coming into effect at the end of this year, and the more you study it, the more implications emerge — for everything from accounting and audit functions, to document management systems, and even incentive compensation.
The new rule itself seems straightforward. Starting with financial statements filed after Dec. 15, public companies will need to start reporting the costs of operating leases as liabilities on the balance sheet. An operating lease covers any equipment where the lessee (you, writing the rent check) have no ownership rights to the asset you’re renting; and the term of the lease is less than the useful life of the asset. Examples include office space, office equipment, aircraft, data storage space, and lots of other items you encounter in everyday corporate life.
Historically, operating lease costs have been buried in the footnotes of corporate financial statements. You can find them in the Commitments & Contingencies section. Typically a company will list its future leasing costs by year for the next three to five years, plus a “thereafter” category for all commitments even longer than that. The disclosure might look something like Figure 1 below, which I plucked from Potbelly Corp.’s annual report filed on Feb. 28.
As you can see, those leasing costs add up — and until now, they’ve all been keep off the balance sheet. Potbelly’s, for example, has $289 million in leasing liabilities; for a company with only $428 million in 2017 revenue, that’s a lot. Plenty more companies are in the same situation as Potbelly’s, with relatively large leasing liabilities poised to pile onto the balance sheet.
So what happens to corporate accounting, and corporate life generally, when that happens?
Lease Liabilities in Proportion
The first priority — the one your CFO and corporate finance team are probably already trying to address — is whether a big spike liabilities could violate a debt covenant or lending agreement your company has. In the worst, most unprepared cases, that sudden spike could even cause a bankruptcy filing.
Broadly speaking, we could look for any company whose leasing liabilities are relatively high compared to total liabilities currently listed on the balance sheet. According to data from Calcbench (disclosure: Radical Compliance does paid projects for Calcbench from time to time), the top 10 firms based on 2017 filings are as follows.
We don’t know if any specific company above is in trouble, because debt covenants aren’t disclosed. Still, this threat demonstrates one compliance concern right away: companies will need strong assurance that they know about all the operating leases they have, so the firm won’t be caught by surprise with some expensive lease a VP of operations signed on behalf of the company but never reported to central command.
That challenge is one part policy management, one part document management. Contracts will need to be structured so all leasing costs are clear. In an ideal world, your contracts will be machine-readable so that IT systems can automatically capture all relevant data and store it in a central repository. Then the accounting, audit, or finance teams can see the company’s latest exposure, and the implications of that for the balance sheet, in a few keystrokes.
I don’t doubt that the S&P 500 are aware of these challenges and working to manage them before the Dec. 15 implementation deadline. (Although if this isn’t the case at your S&P 500 company, always feel free to tell me about it via email! Anonymity guaranteed.)
My concern is for all the smaller public filers, with less mature financial compliance systems and fewer resources. Here’s another chart from Calcbench, showing the off-balance sheet liabilities for the S&P 500 compared to everyone else.
That’s thousands of small firms with potentially large leasing cost exposure. Compliance officers may want to brush up on the issues here, in case the challenges of managing this brave new world spill onto your desk.
Remember the Assets
One question nagged at me as I pondered all these liabilities marching onto the balance sheet. If you want to preserve shareholder equity, then assets and liabilities always need to be equal — so if we add a pile of new liabilities, what gets added on the asset side of the ledger?
“That’s easy,” one accounting whiz told me. “You add the value of the asset you’re leasing.”
Hold on. Grasping that point may be easy. Its implications could be profound.
First, the practical value of that asset might decline over time, while the cost of the lease doesn’t. If that happens, then shareholder equity must fall, because that’s how accounting works. Consider this simple example below.
But you’re a fast food chain, and you signed 10-year operating leases in shopping malls across the country in 2013. Then Amazon and Walmart ramped up online delivery of everything, and foot traffic at shopping malls has tanked. Meanwhile, consumer eating habits have evolved and your greasy fries are out of fashion. So nobody is visiting your restaurants.
Those leases you signed in 2013, however, are still in effect, and their costs won’t change. So now the audit firm is hammering you for a more realistic valuation of those leasing assets, and your balance sheet looks like this.
Shareholder equity fell by 40 percent. That sort of thing gets CEOs deposed and corporations sold into private equity.
Will all companies experience something like that as they put operating leases on the balance sheet? No. And it’s not a difficult circumstance for companies to anticipate, by crafting leases to include emergency exit clauses or clauses where rent depends on other performance metrics.
But again, we’re back to policy management and oversight of leasing activity, so your firm doesn’t fall into such traps. Moreover, you’ll also need to anticipate what evidence your audit firm might want to see to prove that the asset is worth what you claim.
That’s nothing new for assets such as goodwill or inventories — but it is new for this type of asset, which hasn’t existed on the balance sheet before. Now it’s more high-profile. You may need to improve your documentation and evidence, plus the systems to maintain all that documentation.
Return on Assets
The last issue on my mind is how the new standard will change calculations for a company’s return on assets. ROA is a widely used measure of profitability, where net income is divided into total assets. It’s expressed as a percentage; the larger the percentage is, the better the company is at converting the money it invests into profit.
And we’re about to impose a radical change on the assets a company lists. Which will change the denominator in the ROA equation. So you could see calculations change to something like this below —
— with no fundamental change to corporate operations. We just modified the accounting of the balance sheet, by adding $800 in operating leases to the assets.
Will that matter in a practical sense? Probably more to the investor relations department, which will need to communicate the significance of these changes (or the lack thereof) to investors clearly.
A company could, however, have executive compensation — particularly incentive-based compensation — tied to ROA metrics. A sudden change in how ROA gets calculated might lead people to try gaming that number to hit performance targets.
Lots to think about, as you can see from this post. Implementation starts in four months, so if your organization hasn’t started thinking about it yet, you may want to get on that.