How Operating Lease Discount Rates Can Mislead Investors

A new accounting rule added nearly $3 trillion to corporate balance sheets in 1Q19. Operating lease obligations, formerly buried in the footnotes, must now be reported as a liability and  right of use asset – on the balance sheet.

We applaud the FASB for removing the loophole that allowed companies to hide trillions of dollars in capital off the balance sheet. However, the new rule is not perfect. Corporate managers have significant discretion in how they disclose operating lease obligations on the balance sheet. Most worrisome, management can choose the discount rate used to calculate the value of these operating lease obligations.

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We’ve identified two companies, JC Penney (JCP) and Diversicare Healthcare Services (DVCR), that use unusually high discount rates to reduce and, perhaps, understate their reported operating lease burden.

How Discount Rates Impact the Balance Sheet

A company can lease assets in one of two ways: capital leases or operating leases.

Capital leases effectively act as debt to own the underlying asset leased. A simple analogy is taking out a loan to purchase a car or home; payments are made periodically and, at the end of the term, the asset is owned outright with the loan repaid.

Operating leases do not transfer ownership of the underlying asset, and payments are made for usage of the asset. A simple analogy here is leasing a car from a dealer; the lessee makes payments for the right to use the car, but does not gain equity in the car itself and will not own the car at the end of the lease.

However, just as a car is a crucial long-term asset to a household, companies often rely on leases to finance key assets for their business. Retailers often lease the real estate for their stores, and airlines almost exclusively obtain their planes through leases. These leases often cover long time periods (sometimes as long as 99 years), so in effect they function, economically, as a form of debt.

Since operating leases are a form of debt, the lease payments running through income statements represent, in effect, a combination of depreciation and the implied interest payment for the debt. We use the term “implied” to describe the interest payment because there is no official interest payment. There is no official interest rate for the unofficial debt either.

However, under the new FASB rule, companies are required to estimate an implied interest rate. This interest rate is used to discount future lease obligations to their present value, i.e. the operating lease liability they report on the balance sheet. This methodology creates two significant issues:

  1. A company that is already at a high risk of bankruptcy will have a high implied interest rate. This high interest rate means the company will heavily discount future lease obligations, reducing its reported lease liability on the balance sheet. As a result, a high-risk company will appear to have lower liabilities than an equivalent company with less credit risk.
  2. Under the new FASB rule, companies have significant discretion in how they determine the discount rate. As long as it can plausibly justify the value to regulators, a company can use an artificially high discount rate to reduce its reported lease liability.

In order to prevent these issues from distorting our cash flow and valuation models, we use a standardized implied discount rate, 5.1%, across all companies. The 5.1% discount rate equals the mean-reverting weighted average cost of debt for the ~2,800 companies we cover. By using the same discount rate across all companies, we ensure that the operating lease assets and liabilities are more comparable between companies.

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