With the huge growth in securitization over the past decade, banks were able to move large numbers of loans off their balance sheets -- with grave consequences. Outside of financial institutions, the largest source of off-balance-sheet financing is operating leases.

Last week, the Financial Accounting Standards Board (FASB) released a proposal that would bring those commitments right back onto the balance sheet. If implemented, it could whip the rug out from under companies that have been abusing the use of operating leases.

Why companies love operating leases
Under current accounting rules, no asset or liability is recorded on the balance sheet in an operating lease -- despite the fact that the lessee commits to making a set of future payments, much like a form of debt. Capital leases, on the other hand, are recorded on the balance sheet.

Here's the interesting part: Companies have some discretion over whether to account for a lease as an operating or a capital lease. That opens the door to accounting manipulation because operating leases:

  • Feature no lease liability on the balance sheet, understating the company's true leverage, and
  • Feature no lease asset on the balance sheet, raising return on assets.

In these industries, look out for the leases!
The industries that are most heavily dependent on operating leases include retail, airlines, trucking, and railroads.

A high-profile example in the retail sector is Starbucks (Nasdaq: SBUX), which announced in 2005 that certain aspects of its operating lease accounting did not meet accepted standards. As a result, it restated its financial results for 2002 through 2004. In this instance, the negative impact on earnings was very small (on the order of 0.5% annually) and there was no discernible effect on the stock price.

Other companies that have had problems with their treatment of leases include Wendy's International (now Wendy's/Arby's Group (NYSE: WEN)), Sears Holdings (Nasdaq: SHLD), and American Tower (NYSE: AMT).

Would an accounting change hit stock prices?
If companies were forced to put operating leases back on the balance sheet, would it impact stock prices?

In most cases, I expect the answer would be "no," as accounting statements will reflect the economics of the transaction more accurately. However, odds are good we'll witness negative surprises at companies that are currently misstating their leases once the new accounting treatment imposes greater transparency.

Five companies to keep an eye on
The table below contains five companies with significant operating lease commitments and above-average risk of some type of accounting misstatement (as estimated by a model similar to the one I discussed here, but which includes operating leases as a risk factor). Not a reassuring combination.


Total Operating Lease Commitments as a Multiple of Shareholder's Equity

Likelihood of an Accounting Misstatement Relative to a Randomly Selected Company

Liz Claiborne (NYSE: LIZ)

5.90 times

80% more likely

SIRIUS XM Radio (Nasdaq: SIRI)

3.02 times

52% more likely

Pier 1 Imports

2.61 times

Nearly 3 times more likely! (+285%)

CVS Caremark (NYSE: CVS)

0.75 times

56% more likely


0.68 times

61% more likely

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

If you own one of the companies in the table, there's no cause for panic. However, it may be worth reviewing the financials in some detail to ensure you're comfortable with the effective level of leverage -- and to look for any signs of aggressive accounting that would corroborate the model's above-average risk score.

Spotting ticking time bombs for protection ... and profit
Operating leases are just one of many items that are vulnerable to aggressive accounting. In his free report "5 Red Flags -- How to Find the BIG Short," John Del Vecchio, CFA, discusses five red flags that are part of a proprietary model he has spent five years developing to zero in on ticking time bombs. Del Vecchio and his model are battle-tested: As the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points. If you want to put a proven methodology to work for your portfolio, enter your email in the box below.