New Lease Accounting Standards

Beginning January 1, 2019, public companies have to begin disclosing the present value of lease of future lease payments as a liability on the balance sheet. Previously, many leases were kept off the balance sheet. The result will be that for companies that rely heavily on leases, the debt may increase dramatically. However, we would like to make an important point in that while the balance sheet debt will increase because of the new leasing accounting standards, it will only have a minimal, if any, effect on leasing cash flows, meaning that he NAL calculation we discuss is still the correct analysis to determine whether to lease or buy.

Ratios And Lease Accounting

Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.

Darden Split

Darden Restaurants was in the news last year when its Board was effectively fired. Yesterday, the company made a big announcement to split up. More than 430 of the company's restaurants will be spun-off as a real estate investment trust (REIT). The company will then lease the restaurants back from the REIT. Additionally, the company will execute a sale and leaseback on 75 individual restaurants. The plan is expected to allow Darden to pay off about $1 billion in debt.

Amazon's Leasing Cash Flow

In the textbook, we argue that cash flows are most often a better measure of company performance than net income. Amazon fully exploits this concept. In most recent quarters, the company has shown an operating loss, but has touted its positive operating cash flow as the measure that investors should examine. Now, it appears that Amazon may have been glossing over a more negative reality for the company. In the company's most recent earnings announcement, it disclosed another cash flow, which is the operating cash flow minus the capital leases. Amazon has a large number of capital leases. Ignoring the cash flows necessary to pay these leases ignores a significant outflow each year to which Amazon has committed to paying. 

Lease Accounting Change In The Works

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have decided that leases should be reported on a company's balance sheet. The proposed new standard would require a company to report the present value of lease payments on the balance sheet as a long-term liability. Opponents argue that the change would increase debt-equity ratios and companies will scale back operations to reduce debt-equity ratios back to current levels. Another argument against the new rules is that the increased debt-equity ratio would mean that some companies will exceed the debt-equity ratio written into bond and loan covenants. From a financial perspective, the rule changes will have little or no impact as equity analysts have long treated lease payments as a form of debt. Of course, the change will also result in improved performance for these companies, at least to the untrained eye. Because the rule changes increase debt to balance the balance sheet, there will be a resulting drop in the book value of equity, thus increasing ROE.

Lease Accounting Answered

FASB and the IASB have agreed to give corporations a choice of two methods to account for leases, the "right-of-use" method or the "whole contract method". The right-of-use method amortizes the value of a lease and basically treats all leases as capital leases. The whole contract method allows the lessee to expense the lease payments equally throughout the life of the lease. http://www3.cfo.com/article/2012/6/gaap-ifrs_lease-accounting-fasb-iasb-whole-contract-approach

Lease Accounting

Accounting for leasing can be complicated, with both capital leases and operating leases. FASB and the IASB have been working together for the past six years in order to standardize lease accounting and bring more than $2 trillion of leases to companies' balance sheets. A major sticking point between the accounting boards and companies is how leases will be treated on the income statement. http://blogs.wsj.com/cfo/2012/05/22/leases-suffer-identity-crisis/?KEYWORDS=identity+crisis