New Lease Accounting May Roil Retailers

A new study looks at what would happen to some prominent retailers if accounting rules required the capitalization of operating leases.
Alan RappeportJune 14, 2007

Lease accounting hasn’t changed in more than 30 years. But with accounting standard setters now looking to rewrite they way companies show leases on their financial statements, a new study takes a look at what the impact might be on retailers, an industry particularly dependent on leasing. The result, the study says, would be dramatic changes to all three financial statements.

The research, conducted by the Georgia Tech Financial Analysis Lab and based on 2006 financial statements, shows that changes to lease accounting could cause changes to all sorts of financial metrics (View the study). Last year the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) decided make amendments to FAS 13.

Written in 1976, FAS 13 makes a distinction between capital lease obligations, which appear on balance sheets, and operating leases, which do not. FAS 13, writes the study’s lead author, accounting professor Charles Mulford, “is an example of standards setting gone awry.” Though intended to bring more leases onto the balance sheet, writes Mulford, FAS 13’s “bright-line tests have resulted in financial engineering designed to actually keep more leases off the balance sheet.” Most financial and credit analysts, he notes, now routinely adjust financial statements to put leases back into their balance sheet calculations.

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That, in fact, is what the proposed accounting changes would do as well. In effect, they would “capitalize” all operating leases (which make up a great majority of all leases), thus throwing loads of debt onto the books of companies that lease.

“It is clear that [the current practice of] excluding operating leases from the balance sheet causes a material distortion of the financial position of the company,” the study says. It then looks specifically at how the metrics of 19 retailers would change if operating leases were to vanish.

For instance, with their leases moved back on the books, those retailers would see an up-tick in their assets of 14.6 percent. However, the median increase in liabilities would rise by 26.4 percent — an increase likely to rattle the ratios many investors rely upon. The study notes that BJ’s Wholesale, Dollar Tree, and Kohl’s, which all have long-lived leases, experienced 137 percent, 136 percent and 135 percent increases in their liabilities/equity ratio, respectively.

The most significant metric for investors, of course, is earnings. Under current accounting, the study says, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and cash flow appear understated, while income from continuing operations appear overstated. The study predicts that the earnings of retailers would drop dramatically under new lease accounting rules. With operating leases on the balance sheet, income from continuing operations and earnings per share would fall by a median of 5.3 percent, the study says. Companies such as BJ’s Wholesale and Saks could see the most significant drops, as their rising interest and amortization expenses would outweigh their lower rent and income expenses. “An overall reduction in profitability is expected,” notes the study, which estimated a 1.7 percent median reduction in return on assets (ROA) and a 0.6 percent median reduction on return on equity (ROE).

Mulford’s study also shows that the current practice of excluding operating leases from the balance sheet depresses cash flow, because all rent payments are treated as reductions in operating cash flow. Under a capital lease treatment, a portion of cash payments made on leases is recorded as a reduction in lease principal — a financing use of cash. Thus, under new leasing rules, only the interest component of each payment would be accounted for as a reduction in operating cash flow. As a result, the retailers studied would see median 22.9 percent increase in operating cash flow, although the actual numbers ranged from a 1.8 percent increase to a 277 percent increase. Meanwhile, capital expenditures for the retailers studied would rise by an average of 10 percent, and free cash flow (that available for buybacks, dividends and acquisitions) would rise by 51.1 percent.

FASB is expected to issue a discussion paper on lease accounting in 2008, and finalize its leasing rules by 2009.