For the last 35 years, public companies in the U.S. have reported lease obligations differently than other countries, not unlike the way that we stubbornly hang on to English measurements while most of the rest of the planet uses the Metric system.  That is about to change, and change can be painful. 

Here is the premise of the change:  Virtually all leases will be treated as Capital Leases rather than Operating Leases.  Lessees must account for their right to use a leased item as an asset and their obligation to pay future rental installments for that item as a liability.  Simple enough, right?  Remember, this is written by the Financial Accounting Standards Board.  They do nothing simple.  Fortunately they also move with all the speed of, well, the government.  This will give proactive corporations the opportunity to position themselves to avoid pitfalls and structure their future transactions to their advantage.  The discussion paper, which you can view here, is over 100 pages thick. 

I warned of the impending issue back in 2007, in my article titled, The Death of Operating Leases.   Here are some considerations: 

This change will require all corporations, public or not, to show the present value of lease obligations and to have a corresponding opinion of value for the use of the property for ANY lease in excess of some minimum term, likely one to two years.  That will be a huge reporting burden.   In addition, even if of equal value, the offsetting asset and liability will have the same appearance of an asset that is 100% financed, making the company appear far more leveraged that it had been reporting Operating Leases. 

Further, the recent declining market rates can make the asset value less than the liability - not unlike high-mortgaged homeowners who are "under water" - and adding net debt to the balance sheet. 

For some corporations, this impact will be significant.  This has the potential to cause violation of loan covenants, and at the very least will likely make future renegotiation of terms such as interest rates and capital requirements less attractive.  You may educate bankers and loan officers to look past the leases, although they are typically not extremely RE savvy, so don't wait to start these discussions.

Shifting lease obligations onto the balance sheet of corporations will have an immediate negative impact on debt to equity ratios.  For publicly traded firms, it may cause a downward adjustment of their stock value because their debt:equity ratio reflects an increased leveraged position.  If everyone will have to do this, the market will accept the change across the board, right?  Wrong.  Companies with less leased property, more owned property, and shorter term leases will not be effected to as great a degree and the variance between you and your industry peers may be significant.  Regarding the management of quarterly ratios, the obligation will have to be recognized upon lease execution, NOT upon occupancy or commencement of the actual lease term, so timing will be critical.

Operating Leases are traditionally accounted for using a straight-lined rent expense.  Capital Leases are accounted for by applying straight-line depreciation and amortizing interest expense.  As with all loans, the interest is significantly higher in the earliest years of the term, which will cause expense graphs to look like a roller coaster - peaking at the start of a lease and bottoming out at the end.  A way to lessen the thrills will be to use shorter terms which will flatten out the variance.

One seemingly positive effect will be that it will boost EBITDA because rent expense will be eliminated in favor of interest and amortization which are not used in the calculation.   This effect occurs, however, without any actual change in a firm's cash position or obligations.  Since debt, compensation, and earnout agreements are often tied to EBITDA, companies will want to evaluate the economic impact of such a change and word agreements accordingly to allow for the adoption of the new rules.

While an effective date and qualifying details have not been finalized (likely 2012 or 2013), you can be sure of this:  Within the next few years, all leases of significant value will be on the Balance Sheet, and lease costs will no longer be straight-lined on the Income Statement.  So what are you doing about it?

Hopefully, your real estate advisors have come up with an action plan that can be integrated into corporate planning.  In my next post, I'll list some strategies that will help you lessen the impact and strengthen your ratios relative to your competitors.

Because when it comes to adding debt and expense to your financial statements, Less is More.