Next year, S&P 500 companies will add roughly $600 billion (2% of total assets) to their balance sheets. One company will more than double its reported assets (and more than quadruple its reported liabilities).

This swelling of corporate balance sheets won’t come from increased investment or extra cash from tax cuts. It won’t come from any change in the business at all, actually. Instead, companies will add hundreds of billions of dollars in assets and liabilities to their balance sheets due to a new accounting rule that changes the way they treat operating lease commitments.

Investors that don’t pay attention to this accounting rule change will mistake the addition of these leases to the balance sheet for a fundamental change in the business. This risk puts these investors in the Danger Zone.

What’s Changing?

Today, a company can lease assets in one of two ways: capital leases or operating leases.

Capital leases are captured on balance sheets as the liability that funds the asset being leased. A simple analogy is a loan to purchase a car; payments are made contractually and, at the end of the term, the asset is owned outright.

Today, operating leases are not captured on balance sheets. Due to slight differences in operating vs capital lease contracts, there is no official transfer of ownership. The problem is that the underlying economic activity for two companies can be exactly the same while their balance sheets are radically different because one can use operating leases while the other uses capital leases.

This misleading accounting construct has become such a problem that Sir David Tweedie, the former Chairman of the International Accounting Standards Board, gave a speech in 2008 where he said:

“One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.”

Sir David will get his wish. Two years ago, the Financial Accounting Standards Board (FASB) – which governs U.S. GAAP rules – required companies to account for operating lease commitments, and the corresponding right of use asset, on the balance sheet. For more details on this new rule and how we plan to deal with it, read our article “The Impacts of Operating Leases Moving to the Balance Sheet.”