How New Lease Accounting Standards Make Airlines Look Healthier Than They Really Are

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.)

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community InsideFlyer.com, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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Comments

  1. My previous company 5 years ago was privately held and soon to be going public. There were a lot of tricks that they pulled in the months leading up to the IPO to goose their assets and downplay their liabilities.

    The share price started at $55 and is now under $1 (they even had to do some reverse splits so they didn’t get de-listed on the exchange). They have the same number of factories as before (on fewer shifts) producing at least 50-60% of the revenue as before, but stock is now down 98%.

    Lesson: trust, but verify

  2. @Gary. “My own controversial belief, not fully supported by data, is that there’s a lot of ‘slop’ and misreported estimates in corporate accounting”. You just threw the whole accounting profession under the bus. To paraphrase Winston Churchill: USA GAAP accounting “is the worst form of” reporting corporate performance, “except for all the others.” Without standardized GAAP rules of the road, there is nothing for the financial analyst or investor to review. There is a long debated reason for every single GAAP rule. It takes years and a lot of study to obtain a CPA. Show a little more respect.

    On the specific issue you mentioned, operating leases are included in the notes of the financial statements. In the United 12/31/2018 10K, they are reported in Note 11 – Leases and Capacity Purchase Agreements. Most financial analysts would make an adjustment to their leverage calculations based on operating lease payments. For a below investment grade company, like United (BB S&P, Ba2 Moody’s, and BB Fitch {at the time of the 10K}), any decent financial analyst should review cash flow statements.

  3. I’ll weigh in as I’ve done 2 years of consulting on the new lease accounting standard at this point. First, the standard generally will accomplish making GAAP balance sheet numbers more reliable, as most real estate and equipment leases don’t qualify as “variable” and are coming on balance sheet, and external auditors are paying close attention to anything excluded.

    As far as the treatment of true variable costs based on usage, that is more or less unchanged from previous accounting, so nothing is getting worse under the new standard, in fact now companies have to explicitly disclose how much cost they left off balance sheet when they considered it “variable lease cost”

    The discount rate thing… is true but is directly related to their corporate bond/credit rating, you’d already know it’s a riskier debt company from that rating (i.e. A vs. BB)

    Your overall point is right, companies will try to pursue methods to make their financial statements look better, but standards like this and rev rec are closing some of those loopholes

  4. As a CPA with 30 yrs experience. This is not good putting leases on the balance sheet. What it is going to do is put a long term asset that is NOT. Cash in the books the puts current liabilities on the books and long term debt in the books. Current ratios are going to look bad debt to equity is going to be worse and the company is going to have a lot of debt on the books that may never happen. For example AC Moore is closing 145 stores all that lease debt would now come off since the stores are closing. On the other hand walmartbis in the 24th year of its 25 year lease. So theirs is understated

  5. Simple ratios like ROA will actually look worse going forward, but the truth is that this is distortion is nothing new. Analysts who regularly follow airlines already convert your leases to assets to make apples to apples comparisons when comparing financials.

  6. Tim agree bakers and investors look at cash flow that is it. EBITDA earnings before income taxes depreciation amortization..

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