Generation Rent

Say Hello to $3 Trillion in Forgotten Debt

IFRS 16 is coming, and it may have ugly consequences.
At Closing, April 23rd
54.61 USD

Companies have been on a borrowing binge, but you wouldn't always know the full scale of their liabilities by looking at the balance sheet. This makes it hard for investors to compare businesses that fund their activities in different ways. Happily though, that's about to change.

How come? The answer is buried in the notes to financial statements (you know, the ones you don't bother reading). It's here that companies have parked about $3 trillion in operating lease obligations, according to Bloomberg data. 1  For non-financial companies, those obligations equate to more than one quarter of their long-term (on-balance sheet) debt. 2  

Operating leases are actually pretty similar to debt. They represent money companies will be obliged to cough up in future to rent things like planes, ships and retail floor space. But right now you won't find them on the balance sheet. 3

Lease Leaders

These companies are among the largest users of operating leases

Source: Bloomberg

Shows latest full year. Some data were excluded as assumed to be anomalous

From 2019, this will change. New accounting rules called IFRS 16 4 will force companies to include operating lease commitments as part of their reported debt and assets. 5 Heavy lease users in the retail, telecoms, energy and airline sectors will probably be most affected. 6

Leverage Hangover

IFRS 16 will cause debt to balloon. In some cases, it'll be ugly

Source: PwC

Based on analysis of the operating lease commitments of 3,199 entities worldwide that report under IFRS (excludes U.S.)

The upshot: this is going to make companies appear far more leveraged. Debt will increase compared to equity. At the same time, earnings before interest, taxation, depreciation and amortization may increase because leases will be depreciated, not expensed. Retailers can typically expect an Ebitda uplift of more than 40 percent, PwC found.

The impact on reported liabilities is likely to prove most significant though.

I sympathize if you're tempted to dismiss this is as another dull accounting exercise. Total cash flow won't be affected, and cash is what pays the bills and determines the value of a business. Furthermore, rating agencies and analysts already adjust for leases when assessing credit-worthiness . 7  

Some companies already spell out the impact of leases on total indebtedness. Air France-KLM's reported net debt is 3.7 billion euros ($3.9 billion) but its lease-adjusted net debt is 11.2 billion euros. The present value of Tesco's operating lease commitments is one and a half times the size of reported net debt, according to its 2016 annual report.

Even so, I doubt this transition will be painless. At the very least, the rule change should give armchair investors, not to mention a company's customers, employees and suppliers, a much better idea of how risky a business is compared to rivals. For some folk, this will be a nasty surprise. Worries about corporate leverage are already widespread.

Besides, companies aren't always as forthcoming as you might hope. Some airlines make debt adjustments for aircraft leases but not for other off-balance sheet rental agreements such as airport buildings. Delta Air Lines Inc. reported $6.1 billion in adjusted net debt at the end of December, including $2 billion in aircraft rent liabilities. Yet the discounted value of all its operating leases is closer to $9 billion, Gadfly estimates. 8

Importantly, there's precedent for seemingly cosmetic accounting changes to impact valuation. Last year, British aircraft engine maker Rolls-Royce Plc said it would report lower profit under a separate new accounting standard (IFRS 15). Its shares fell even though it stressed that cash flow would stay the same.

Accounting reform can also affect corporate behavior. When British companies had to start recognizing the full liability for defined benefit pensions on financial statements, a lot of those "final salary" plans ended up closed.

It's conceivable therefore that IFRS 16 will affect corporate decisions on whether to rent or purchase an asset. Consider sale and lease-back arrangements. These were once a popular way for companies to get their hands on some cash and a quick chance for executives to make themselves look like geniuses. All of a sudden, return on assets improved.  

Now, if all that rented floor space has to sit on the balance sheet anyway, selling off the corporate silverware might become less attractive. Buying big ticket assets, rather than leasing, is also cheaper now because of low interest rates.

Another approach may see some companies partly embrace shorter lease terms to minimize the balance sheet liability, according to Ruxandra Haradau-Doser, aviation analyst at Kepler Cheuvreux. Shorter leases are already common in retail, albeit for different reasons. With sales migrating online, retailers want more flexibility to close stores. IFRS 16 could accelerate that.

Rental Culture

Airlines and retailers are big fans of operating leases

Source: IASB

Shows present value of future operating lease payments as a proportion of total assets

The accounting changes could also lead to more volatility in financial results, according to James Stamp, a partner at KPMG. Airlines typically take out aircraft leases in U.S. dollars. If the carrier's domestic currency weakens against the dollar, its liabilities would suddenly increase and it would have to take a currency hit against earnings. Stamp thinks demand for hedging will rise.

Far from being academic, the accounting changes will have an effect in the real world. Some may be profound.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. This figure isn't discounted. The present value of global lease payments is about $2.2 trillion, according to an IASB estimate. It compiled data from 2014 annual reports. More than 80 percent of that total relates to just 1145 companies. 

  2. Again on an un-discounted basis. 

  3. Finance leases are different. These are already included on the balance sheet. 

  4. U.S. companies will apply a new FASB standard that's broadly similar to IFRS 16, albeit not in all respects. 

  5. If describing something you rent as an "asset" seems odd, remember that a lease isn't just a financial obligation, it also represents the right to use that asset.

  6. There are exceptions for oil and gas exploration leases. 

  7. A widely used approximation is to take the annual rental expense and multiply it by seven or eight times.

  8. Using the industry's standard calculation of 7 times annual rental expense ($1.3 billion for Delta). 

To contact the authors of this story:
Chris Bryant in Berlin at
Andrea Felsted in London at

To contact the editor responsible for this story:
James Boxell at

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