These changes coming to our accounting practices were proposed so long ago, I actually forgot about them. Of course, if your business is small enough to keep using cash accounting practices, the new requirements will just roll off your back.
Which, of course, begs the question- who can use the cash method of accounting? The first test stipulates that any company that has averaged $ 1KK in sales for the past three years is not eligible to use cash accouting. The second test- any C corporation that has $5 KK in sales in any year must use accrual accounting. And, then there’s another consideration. While the IRS does not police this rule often, it is their position that any firm that generally sells merchandise (and, therefore, has inventory) must use accrual accounting.
This means firms like ours are going to have to adjust our thinking and planning. Because our office lease, our equipment lease, and our car leases are going to make our firm (and many, many others) look a lot less healthy. Because we must really account for these leases on our balance sheets. Airline operators, producing firms that use rail transportation, trucking firms, and a slew of others- will now be adding some $ 2 trillion of liabilities to their balance sheets. Which will certainly erase a lot of the equity (value) they have been depicting in the past.
You see, the FASB (the Financial Accounting Standards Board) now stipulates that leased items such as real estate, office equipment, aircraft, and the like shall be listed as obligations on balance sheets. Not as of right now- but starting three years from now (2019). FASB considers these leases akin to debt; instead of being found in footnotes to our balance sheets, they will be clearly found under our liaibilities.
When we list the leases via asterisks and footnotes, folks can’t see how much our obligations against future earnings are encumbered. It’s why it has been lucrative to lease rather than buy (on credit), since our equity value has been kept whole if we leased. A purchase or a loan would reduce our cash, subject us to depreciation rules, and other aspects that may serve to have our firms now appear much weaker due to the standards change.
As opposed to financial ‘adjustments’ we will discuss tomorrow, for now, these ‘off-the-books’ leases have been totally legal. For example, until this change AT&T has been reporting long term debt of $76 billion under the old rules. But, in 2019, their obligations will increase by 1/2 to $107 billion under these rules. Or, consider CVS doesn’t own the real estate it uses for its drug stores. It’s debt will skyrocket from under $12 billion to more than $39 billion with these changes. Airlines like Delta that have seemingly turned the corner since the 9-11 debacle and the recession will now reflect $21+ billion in debt, rather than the $8.5 it heretofore disclosed.
And if you’ve been paying attention to the demands that LBO (leveraged buyout firms) and activist investors (amazingly, we don’t call them for the pirates and blackmailers they are) have been demanding of our public companies , then you will recognize how they’ve just blown up a slew of companies. Because many public companies accepted the blackmail terms to sell off their real estate (to pay the pirates their fees) and now have horrendous debt obligations on their balance sheets instead of the real estate assets they shed to satisfy the ‘activist’ demands.
Yup, tell me again that these activist investors aren’t pirates
I think I almost understood about half of that. And on the one hand, it doesn’t really seer to change anything but stockholder perception–in other words, if they understand how the accounting has changed, rather than the actual health of the company, there’s no realistic reason to change investor behavior. But of course they won’t, so how will it change corporate behaviour? Will there be a renewed shift toward allowing people to work from home, or cramming them into cubes and “open” spaces to even further reduce office space? Will they buy more real estate after divesting? What do you think the real impact will be on the economy?
Holly Jahangiri recently posted..Artistic Impulses
Thanks for the question, Holly.
First- see my reply to Karin.
Now, for larger firms, the ones that have been selling off their real estate to satisfy activists with their greenmail demands (better known as blackmail to the rest of us), there’s going to be a heap of trouble. Had McDonald’s agreed to sell off its real estate (as demanded), it’s worth would have been decimated. sure, the extra cash paid off the activist- and might have paid dividends to the rest of us. But, after that, showing the lease costs for their property means they have little net worth.
And, that’s exactly what happened to the big department stores that did that, too! (It cuts into their ability to borrow funds to stock new inventory, since their worth has been decimated by selling off their real estate assets.)
I don’t disagree with having to post leases as debts. It seems like shady accounting not to list them as debts, when, in fact, they are a debt.
OK. I’ll agree with you in principle.
But, let’s assume to ensure you are a small business- and you sign a 10 year lease. And, your monthly payments are $ 5000 a month. You now have added $ 600K of debt to your balance sheet. if you had a $ 250K investment (equity) to start, you have a $350K negative net worth- and no bank will loan you money (even for a line of credit).
Before, the bank would look, see you had $ 250K of equity, a potential for profit (after the monthly lease costs) and loan money.
It’s a double edge sword, karin.
Thanks for the visit AND the comment.