Sunday, October 27, 2019

Yes, yes — we talk constantly about the new standard for disclosure of operating lease costs, and we just published an in-depth report about the new standard’s effect on the retail sector.

Well, we have even more. Today we look at how the new standard changes the return on assets for two of those retailers: Burlington Stores ($BURL) and Michaels Cos. ($MIK).

Return on assets (ROA) measures how efficiently a firm manages its assets to create a dollar of profit. It’s calculated as net income divided into total assets, and is expressed as a percentage. The higher the percentage, the more efficiently a firm puts its assets to work to make money.

But wait! The new leasing standard (ASC 842, if you care) requires firms to report the value of leased assets on the balance sheet. Mathematically, that means the standard is increasing the denominator of the ROA equation.

So could a firm see its assets expand so rapidly that ROA actually falls, even if net income goes up? Yes it could. Burlington Stores and Michael’s Cos. are two cases in point.

See Figure 1, below. It compares their net income and assets in Q4 2018, just before the ASC 842 standard went into effect; with the same numbers in Q2 2019, after ASC 842 arrived.



As you can see, ROA for both firms fell sharply, solely because of ASC 842. We calculated what their Q2 2019 numbers would have been without operating lease assets included. In both cases, ROA would have risen.

That change in operating metrics isn’t necessarily disastrous. After all, the business operations themselves didn’t change to any material degree; accounting rules did. The trick for firms in this predicament is to communicate the reasons behind that change clearly and effectively, so investors won’t misunderstand what’s happening.

Now we’re off to pick up a new coat and some crafting supplies. Winter is coming and we want to decorate our laptops for the holidays.


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