Companies With Big Hidden Debts

In about two years time, U.S. companies are suddenly going to become a whole lot more indebted, at least according to their balance sheets. Currently, companies are carrying around $3 trillion worth of off-balance sheet liabilities in the form of operating lease obligations. But, those operating leases will soon have to be recorded on the balance sheet under new accounting rules that are set to come into effect in 2019, according to Bloomberg.

Hidden Debt

Petrobras is by far the largest user of operating leases with a total of $97.8 billion worth. Next in line are Sinopec with $54.0 billion, Walgreens Boots (WBA​) with $34.1 billion, AT&T (T) and Petrochina tied with $29.7 billion, and CVS Health Corp (CVS) with $27.2 billion. For all of the companies looked at by Bloomberg, operating leases were equivalent to one fourth of their long-term (on-balance sheet) debt.

To finance the use of assets like real estate, aircrafts or other equipment with long useful life spans, many companies make use of operating leases, which represent a rental agreement of an asset from a lessor. As a rental agreement, a lessee is able to make use of an asset without having to add the asset and associated rent liabilities to the balance sheet. Yet, the rent liabilities are still obligations that require future payment and thus they are not that different from debt. (For more, see: Uncovering Hidden Debt.)

New Accounting Rules

For those that are not in the habit of reading the notes to a company’s financial statements, these lease obligations can go completely unnoticed. However, new accounting rules called IFRS 16, set to commence in 2019, will oblige companies to explicitly account for operating leases on the balance sheet with the rest of their debt and assets.

When this happens, many companies are going to suddenly look a lot more leveraged. While the difference will be significant for companies in sectors such as healthcare, telecoms and airlines, the most dramatic effect will take place in the retail sector, where the median increase in indebtedness for firms due to the new accounting rules will be nearly 100%.

While this is not an actual increase in financial obligations that would affect a company’s credit worthiness, since rating agencies are aware of operating leases and make the necessary adjustments in performing their analysis, the appearance of all this additional debt on the balance sheet will make it easier for the average investor to assess the risk of a company and make comparisons with others. (For more, see also: Soaring Debt Risk for Retailers After Bruising Web Wars.)

Equipped with this newfound awareness, average investors may soon begin to follow the lead of recent hedge funds placing bearish bets against American retailers. By one metric, according to Bloomberg, short positions on some of the riskiest slices of commercial mortgage-backed securities (CMBS) have jumped 50% from a year ago.

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