Actual Company Debt

Do you really know your actual company debt? This may seem like a silly question, but there is more to it than you may think. Let me explain.

Leases

There is a proposal from U.S. and international accounting regulators to change how a company should record and account for what is referred to as operating leases. Here I just want to consider the impact on the lessee. First, let’s look at some definitions of two basic lease types.

Capital Lease – These are leases for things like equipment where the equipment value is recorded on the lessee’s balance sheet and depreciated. Likewise, the lessee records the debt for this equipment. This is very similar to simply financing the purchase of equipment, but because of how it is structured it is considered a lease. Certain rules require it to be recorded on the balance sheet, but I won’t get into those here.

Operating Lease – This is a lease typically for things like office space. It could also be for things like autos and equipment. Because certain conditions are not met, under current rules it does not have to be classified as a capital lease or recorded on the balance sheet. The lessee simply records the lease expense each month. If the lessee does not have to make payments immediately there are some special considerations as to how expense is recorded, but again that is beyond the purposes of this article.

A Big Change is in Store

Although it has not been implemented yet, the proposed changes to accounting for operating leases of over one year will make them look more like a capital lease. So, what does that mean to your company if you have operating leases?

While in the past a lessee has not had to record the asset value or the liability of an operating lease, if these proposed changes are implemented that will change. If so, a lessee will be required to record an asset value for the lease and depreciate it. Likewise, the obligations of the lessee for payments will need to be recorded as company debt.

Why the Change?

Basically, from the standpoint of a lessee, the change has to do with presenting more clarity of the company’s debt obligations. In the past, the obligations for future payments on operating leases have merely been reported as a footnote to the financial statements. Yet, the reality is that these obligations may have significant impact on whether a company will remain profitable and generate adequate cash flow. Not only does this present a clearer picture for the lessee, it also gives existing and potential creditors a clearer picture of the lessee’s financial condition.

Some Confusing Implications

This new method of accounting for operating leases has implications that extend further than just the numbers on the financial statements. It also impacts financial ratios. For example, imagine a company has an operating lease with future payments of $500,000. The calculation of debt-to-equity is just an example of many financial ratios that will significantly change if the lease must now be recorded on the balance sheet.

There have been a lot of comments both for and against this proposal. Frankly, I can see both sides of the issue. But, when I stop to think about it, doesn’t this proposal present a more accurate picture of company debt? I suspect an underlying reason for resistance to this proposal is that change is hard, especially when it has a big impact and/or it upends a long-standing practice.

A Caveat

As I read some of the feedback to this proposal there was one thing that stood out as somewhat as a flaw in the thinking behind this. Any time a company takes on an obligation for future payments there is in essence a debt obligation. For example, when an employee is hired and the intent is to keep them more than a year, there is an implied obligation for future payments of wages, taxes, insurance, and perhaps other things. Of course, a company may be at liberty to terminate an employee at will, thus removing any obligation for future payments. But, should employees with long-term employment contracts be accounted for differently? What other obligations fall into this same scenario. While the proposal does not mandate changes to these items, they do point to the difficulty of fully assessing a company’s long-term debt obligations.

Let’s face it, No accounting method is perfect and there will always be things that add an element of ambiguity to a company’s financial picture. That said, the key seems to be that users of financial data understand just what it does and does not consider.

Will you be ready should this change to accounting for operating leases be implemented?

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

Share

Leave a Reply

Enter your email address:

Delivered by FeedBurner