Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

How Healthy Is the Balance Sheet with All Those Leases?

Common Investing Pitfall: How Healthy Is the Balance Sheet with All Those Leases?

Many retailers use operating leases to "rent" space for their stores. Because these leases aren't capitalized and are kept off the balance sheet, they understate a firm's total financial obligations and can artificially inflate financial health. The leases aren't inherently bad or sneaky; in fact, their existence is core to most retailer's expansion plans. Lease obligations can be found in the footnotes of a firm's 10-K under the heading "commitment and contingencies."

Be sure to give a retailer a thorough checkup before declaring it to be in tip-top financial shape.

For example, Tommy Hilfiger appeared to have pretty good financial health going into 2002. The firm had $387 million in cash and $638 million in total debt. However, the specialty apparel firm also had $273 million of future financial obligations in the form of operting leases. If we add off-balance sheet leases to the debt on the balance sheet, the toal comes to $911 million, and the coverage ratios don't look as robust. Tommy Hilfiger entered 2002 with declining sales and stagnating profits and cash flow. When Hilfiger announced that it neede to close many of its retail stores in October 2002 and pay to break the leases, the stock price was hammered.