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Capital Ideas: The Leaseback Effect

Accounting treatments of sale-leaseback deals can distort free cash flow, a new report reveals.
Marie Leone, CFO.com | US
December 16, 2004

Last December, casual-dining chain O'Charley's Inc. sold six restaurant properties to an unrelated entity, CNL Restaurant Capital LLC, and then leased them back under a 20-year operating-lease agreement. The Nashville-based company recognized a gain of about $17 million on the transaction and, for accounting purposes, considered the transaction a financing event.

Finance executives at the company say they viewed the chain's sale of unappreciated assets as a way to raise capital, like issuing debt or equity. Since those moves would have been reflected on O'Charley's cash-flow statement as a financing activity, that's how the executives recorded the proceeds from the transaction: as cash from financing.

The accounting treatment seems like the logical way to book such a deal. Yet, according to a new study, O'Charley's is clearly in the minority when it comes to how it records the sale proceeds from sale-leaseback transactions.

The research, conducted by the Financial Analysis Lab at the Georgia Institute of Technology, looked at 37 nonfinancial public companies that entered into operating leases through large sale-leaseback transactions over the last six years. booked Thirty of the companies booked the sale proceeds as cash from investing, while just seven reported the sale proceeds as cash from financing activities.

That's understandable, since companies that book the deals as cash from investing can include the proceeds in their free-cash-flow calculations. Companies that account for the deals as cash from financing can't do that.

The problem is that the choice of investing-cash treatment for sale-leasebacks can distort the reporting of free cash flow. For companies that used the cash-from-investing treatment, study co-author and lab director Charles Mulford subtracted the sale proceeds from free cash flow. The adjustment caused significant decreases; for example, companies such as AMC Entertainment, Carmax Inc., and CVS Corp. dropped from a positive to a negative free cash flow.

Mulford stressed that none of the 30 companies violated generally accepted accounting principles and that there's no evidence of ulterior management motives in the choice of accounting treatment. In fact, auditors probably don't focus on the free-cash-flow effect either, says Ben Neuhausen of audit firm BDO Seidman. "Free cash flow is not a defined accounting term" under GAAP, he says. Rather, it's a performance measure.

What Mulford finds more troubling than the distortions, however, is that two companies in the same industry, entering into identical transactions, could report the sales proceeds in completely different ways. That would end any true apples-to-apples comparison of free cash flow among companies. "If a company records the proceeds as cash from investing, analysts and investors potentially can be misled," Mulford told CFO.com.

The consequences are serious, since free cash flow, which measures a company's ability to generate cash, has always been a primary yardstick used by investors and analysts to value companies. What's more, sale-leaseback transactions are a common off-balance-sheet transaction used by many companies to rid their balance sheets of assets while retaining their full use.

The reason for the differences in sale-leaseback reporting is that the measurement and interpretation of free cash flow changes depending on the way a company views the asset disposition. For example, in a straight asset sale, a company disposes of an asset and relinquishes possession of it. As a result, the company's productive capacity shrinks, and the proceeds from the sale can be used to replace it. The proceeds can offset capital expenditures, effectively lowering capex and increasing free cash flow.

But in a sale-leaseback transaction, argues Mulford, a company retains full use of the asset, so the productive capacity is maintained. In that case, a company that uses the proceeds to offset capex gets a double bang for its buck — retaining the productive capacity of the asset and boosting the company's free cash flow.

Companies that view a sale-leaseback as an investing event — interpreting the transaction as generating funds from the sale of property or equipment — take that double benefit. They book the asset disposition as a straight asset sale, and therefore add the sale proceeds into their free-cash-flow calculation.

Companies that view a leaseback deal as a financing event, however, interpret the transaction solely as generating funds, not disposing of an asset, and don't include the proceeds in their free-cash-flow calculation.

The blame for the reporting disparity doesn't fall on companies, according to Mulford and his co-author, Amit Patel, a graduate research assistant at Georgia Tech's College of Management. Rather, it's unclear under GAAP how to account for sales proceeds arising from sales-leaseback transactions that involve operating leases, according to their report.

The cloudiness, however, is unlikely to clear up soon. With other issues taking center stage at Financial Accounting Standards Board, Mulford says, the accounting standard setter isn't moving on FAS 95 ("Statements of Cash Flows") projects.


For his part, Donald Nicolaisen, the Securities and Exchange Commission's chief accountant, has noted that "investors express a strong preference for use of the direct method of preparing statement of cash flows." That method is a more transparent reporting regime that could end some of the discrepancies related to booking the proceeds gained from leaseback transactions, he suggests.

Interpreting Nicolaisen, Mulford says, "the issue of cash-flow statements needs work."

Marie Leone's "Capital Ideas" column appears every other Thursday. Contact her at MarieLeone@cfo.com.

Disclosure: the writer of this article holds a retirement investment in CNL Properties REIT Inc., the parent company of CNL Capital.




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