Street Capitalist: Event Driven Value Investments

At Street Capitalist we’ve focused a bit on restaurants and retailers as of late – in particular we’ve highlighted some of the quirks to look out for in their accounting. It looks like we’re going to see some changes to how lease obligations are accounted for:

Investors brace for dramatic accounting change. That sounds like a fantasy headline from one of the great geeky professions, but it’s almost true. New rules announced on Tuesday on lease accounting will increase the average company’s debt load by 58 per cent, according to PwC and Erasmus University.

The issue: with the right kind of lease contract, companies currently keep assets off the balance sheet that are both durable and vital to operations – for example airlines’ aircraft and retailers’ stores. But accountants are on the way to banning these operating leases. Almost all leases will be considered financial, so both the assets and the corresponding discounted present value of future payments will be on the balance sheet. The result: the average retailer can expect a three-fold increase in debt levels. For Tesco, an extra £15bn of lease liabilities will be included into a pool barely £200m deep.

The results of the new rule, a joint project of the International Accounting Standards Board and the US’s Financial Accounting Standards Board, may surprise many investors. But not lenders and credit rating agencies, which already make similar calculations. They will have to decide whether the new measure of the value of leases is better than their existing rule of thumb, multiplying rental expense by seven. PwC believes the official measure of the liability will be lower in more than nine out of 10 cases.

Lease Accounting (FT Lex)

PWC has a report (PDF / Google Docs Viewer) which explains these changes in greater detail.