Regular readers know that this blog is only one of the things that I do. I have a full time day job, and I’m fortunate to be surrounded by people much smarter than I am. As a result it’s challenging and exciting and I’m always learning.
The head of one large privately held company once shared his frustration looking under the hood of public companies they’ve considered acquiring, offering for instance that they may purposely avoid understanding whether a given manufacturing plant is making or losing money – out of fear of having to write down the asset if they knew what was happening. A former head of the Financial Accounting Foundation, parent of FASB and GASB, was similarly concerned about the perverse incentives created by accounting rules.
The Wall Street Journal flags an issue with new accounting rules for leases. Long-term leases with fixed payments (including those whose payments rise by fixed amounts) now have to go on balance sheet, while variable payment leases do not. Airline gate leases are predominantly variable because “rates can [often] vary depending on factors such as airport operating costs and use of the facilities.”
Variable leases “are excluded because they may never happen, and so the leases don’t meet the definition of an asset or liability.” Yet “[v]ariable leases can be a big chunk of lease costs for carriers: 48% for Delta, 54% for American Airlines Group Inc., 69% for United Airlines Holdings Inc. and 77% for Southwest Airlines Co.”
Another perverse result of the rule, which makes a lot of sense in the abstract is,
[T]he interest rates companies pay on their debt can be used to discount the future value of their leases. Risky companies pay higher rates, and so benefit more than safer companies in discounting their leases, thereby reducing their reported liabilities.
The worry here is when either:
- We believe that GAAP-reported numbers are the full and complete picture of a business (whether or not lease costs are reported as liabilities affects a company’s leverage ratio), or
- Businesses alter their behavior to drive better GAAP numbers
In either case accounting standards can be misleading. I worry more about the latter case, where behavior chases the numbers rather than ultimately driving better free cash flow. The perverse incentive is to structure leases in a way as to avoid reporting them as liabilities.
Just as it’s important to remind industry watchers the role that frequent flyer programs play in driving airline profitability it’s important to realize that’s not in the numbers as well as what’s included – although I believe that in some measure the market actually prices these things in fairly already.
My own controversial belief, not fully supported by data, is that there’s a lot of ‘slop’ and misreported estimates in corporate accounting – entirely apart from and beyond the airline industry – and there are potential land mines hidden in plain sight all over the place because gaming of numbers and willful blindness are problems that replicate themselves across decisions throughout companies.
(HT: Jeff W.)