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General Electric is making an accounting change that'll make its one biggest problems look less severe

02/04/2019 / Ethel Jiang / Business Insider

General Electric's cash problem will look better in 2019 after an accounting change takes effect, an accounting professor says.

For reporting periods beginning after December 15, 2018, all public US companies should apply a new accounting standard that requires them to recognize financing-lease assets and operating-lease assets on their balance sheets. The previous accounting term only required companies to recognized capital lease-assets.

With the financing-lease assets and operating-lease assets now being counted as capital expenditures (CAPEX), companies' free cash flow (operating cash flow minus capital expenditure) will look different than they used to, Charles Mulford, professor of accounting at Georgia Institute of Technology, told Markets Insider. Companies that are not growing their fixed assets quickly, or are reducing them, such as General Electric, will see a positive adjustment in their free cash flow, and vice versa, he added.

According to Mulford, a simple scenario for a capital lease is taking out a loan and spending that money on new equipment. Under the previous accounting standard, the equipment gained through this lease shows up as a CAPEX on the financial statement.

In the case of using a finance lease, companies negotiate terms with a bank, which wires the money directly to the equipment lender. As companies didn't really touch the money, though still purchased the equipment, the equipment was not reported on the financial statement and only showed up in the footnote. But the new accounting standard sees it as little different than a capital lease, and thus requires it to be recognized as a CAPEX.

Operating leases do not transfer ownership of the new equipment, and payments are made for usage of the asset. A simple scenario is when leasing new equipment from a lender, the lessee makes payments periodically for the right to use the equipment — but does not gain equity in the equipment itself and will not own the equipment at the end of the lease. This type of asset is now required to be recognized on the balance sheet under the new accounting term.

Since companies' 2019 financial statements are not out yet, Mulford did the math on his own.

Finance-lease assets, in his eyes, can be viewed as non-cash CAPEX showed in the financial statements' footnotes. Therefore, by adding the non-cash CAPEX to CAPEX, companies that disclosed non-cash CAPEX, such as Amazon, would see their free cash flow lower. General Electric didn't post any non-cash CAPEX in its footnotes — at least from 2015 to 2017 — thus it was not affected at this level of adjustment.

Operating-lease assets should be recognized by their capitalized value, which represents what these assets would cost if they were purchased for cash, according to Mulford. He calculated the capitalized value of companies' operating-lease assets by applying a multiple to their annualized rent expense changes. He also added back the rent expense that year in the operating cash flow to avoid double accounting — since rent expense was already subtracted in the previous term. At this level, GE's free cash flow was adjusted higher because GE's rent expenditure that he added back is higher than the increase in GE's capitalized value of operating leases.

Companies like GE that are limiting their fixed assets will see the same phenomenon, with the adjustment being a positive one, raising adjusted free cash flow above the reported amount, said Mulford. He added that his calculation is just for reference, and when companies' 2019 financial results are reported later, they are required to recognize the two lease assets on their balance sheets. Based on GE's 2017 financial statement, its most recently disclosed annual statement, Mulford sees GE's free cash flow improving by about 2.4% under the new accounting term.

Recently, General Electric has sped up efforts to reduce debt and free up cash. In June, General Electric announced a massive reorganization, saying it would spin-off its healthcare business and split from the oil giant Baker Hughes. The conglomerate also said it would reduce its debt by $25 billion in an effort to shore up its balance sheet.

Last October, GE announced it was taking a $23 billion write-down on its power business, which it was also splitting in two, and slashing the company's dividend to a penny.

And last Thursday, the company said GE Capital sold off $8 billion of assets in the fourth quarter and brought its debt load down by $21 billion. GE also announced that it reached an agreement in principal for a $1.5 billion settlement with the Department of Justice over WMC, its defunct subprime-mortgage business.

GE was up 28% this year through Monday.

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