Friday, March 13, 2009

What's the impact?

The chairman of the IASB, Sir David Tweedie, has said as a half-joking example of the need for lease accounting reform that it's his life's ambition to fly on an airplane that's shown on the books of the airline flying him. This slightly overstates the situation (for instance, United Airlines' annual report shows capital as well as operating leases, as well as some owned aircraft), but it is true that corporations have made huge commitments through operating leases that currently have no impact on the balance sheet (aside from the possible impact of leveling scheduled rent increases) and are only reported as a footnote to the financial statements. (United's operating lease commitments are nearly 3 times its capital leases, and include the majority of its aircraft.) The SEC recently estimated that the total value of future rent commitments in the U.S. is $1.25 trillion (yes, that's with a T).

In mid-2007, the Georgia Tech College of Management's Financial Analysis Lab did a study looking at the impact of forcing operating leases to be capitalized on a number of presumably representative retail store chains. Chain stores are one of the industry groups likely to be most affected by forcing all leases to be capitalized, as the FASB & IASB intend. While the Lab didn't have complete information available to calculate precise results, their estimates were stunning: while the impact would be modest for many stores, they estimated that BJ's Wholesale could face an 80% drop in reported earnings per share. (The median impact was a much more modest 5.3% drop, still significant, and likely to be larger in the current difficult retail environment.) The effect on stores' leverage was even more significant: the median increase in the liabilities to equity ratio was 26%, and several companies would see that ratio more than double.

What would be the impact on loan covenants? We don't know. It might be minimal, as some banks already require their borrowers to treat operating leases as capital for covenant calculations. Yet there are probably other lenders who haven't taken that careful a view of operating leases; if a borrower suddenly doubles its reported debt load, they could easily find themselves either in default or facing penalty interest rate hikes.

The FASB/IASB haven't said how they plan to transition to the new regime of capitalizing leases that are currently operating. The most likely scenario would seem to be booking the remaining rent commitments at the effective date of the new regulation, rather than restating from inception. Some people are holding out hope that existing leases would be grandfathered, but that doesn't seem to mesh with the boards' stated intention of recognizing the "economic reality" that leases convey a benefit and obligation.

FCS has been providing indenture reporting capabilities for our clients for years, calculating operating leases as capital at either a single rate or a series of rates based on our customer's cost of debt at different terms. EZ13 allows users to use either the incremental borrowing rate or a fixed interest rate to capitalize operating leases, without changing the lease record (so that regular and indenture reports can be run without changes).

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