Every company should maintain accounting records by the Companies Act. Accounting rules are statements that guide how to record transactions.
A new corporate accounting rule is about to pull a roughly calculated $3 trillion out of the shadows.
From this year, companies have to record the cost of renting assets used in their processes like office space, equipment, planes, and cars, on their balance sheets rather than hiding those cost in the footnotes of their financial statements. The new accounting standard should be appreciated.
The result will be estimated 3 trillion dollars added to accountability on their books. Till now, only leases that led to obtaining the asset were accounted in this manner. This change, by the Financial Accounting Standards Board, will make it simple for investors to analyze a company’s financial obligations.
Sheri Wyatt, a partner at accounting firm PricewaterhouseCoopers, said “It’s going to affect all companies’ leverage. They will have more liabilities on their books than they had previously.”
Morgan Stanley awaits the consumer discretionary sector to face the largest surge in debt because of this change, and the approximate financial ratio for the retail sector to increase to 3.4 times from 1.2 times.
Unites States public companies are pledged to a total of $3 trillion in operating leases, according to the International Accounting Standards Board. Companies with high amounts of operating leases which includes retailers and restaurants that lease properties and airlines and shipping companies that lease airplanes, cars, and ships.
It may put pressure on investors, including quantitative funds, to shift the way they use to measure particular financial criteria while making their investment decisions. Leverage — measured in the ratios of debt to earnings or debt to equity — is a fundamental number used when calculating a company’s risk.
Analysts and sophisticated investors had not ignored the high amounts of lease obligations when calculating debt ratios. For many years, they have been capitalizing leases by doubling the annual rent expense by eight times to get the estimated value of the remaining lease payments. However, the values companies now have to put on their balance sheets may appear different than those estimates.
Todd Castagno, the equity strategist at Morgan Stanley, said:
“I do think people will have to adapt to new metrics – and they may be surprised. The liabilities and assets that companies report may look very different from the ad hoc estimates that people have used in the past,”
“Those very common metrics that people look at to value equities, to look at performance, to screen for high-quality stocks, all those ratios are going to change,” Castagno said.
The change in company leverage will affect some quantitative funds that use leverage as a screening method.
For instance, the MSCI Quality index uses debt to equity as one of the metrics to rank the companies. If a company’s debt to equity ratio changes crucially due to the new accounting standard, it will get screened out of the index.
“You might have different companies moving in and out of what you define as quality depending on how these ratios change,” Castagno said.
To be certain, the extra liabilities on the balance sheets should not have a negative outcome on company credit ratings as they are already taken into account.
“We don’t expect a significant rating impact,” said Kevyn Dillow, accounting analyst at Moody’s Investors Service. “The credit quality is not changing. Moody’s estimate of a lease obligation is pretty precise in that we calculate a present value based on the company’s disclosures.”
In the way of increasing the complications, few data vendors haven’t incorporated lease liabilities into companies’ total debt amounts, and will not be in the future. Depending on the platform that investors are using they will get a different number.
For instance, Refinitiv financial solutions will not treat operating leases as debt for United States companies and treat only as non-debt liabilities on the balance sheet, to
“Allow clear comparability of reports across companies, markets, and accounting standards,” a spokesperson said in an interview.
It is to be noted that it will only add the lease liabilities to debt for companies filing under International Financial Reporting Standards which are mostly in the European Union, Asia, and South America.
Bloomberg Terminal is already integrating lease liabilities in company debt.
FactSet (INTEGRATED SOFTWARE & DATA SOLUTIONS FOR INVESTMENT PROFESSIONALS) said in an interview that it would capture the operating leases as part of the debt in the next reporting.
“Some of the data vendors are adjusting, and some of them aren’t. Depending on what data vendor you use, you are going to get very different metrics. I think people are concerned with that,” Castagno said.
