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Earthquakes and Enterprise Survival February 2, 2010

Posted by Bob Cook in Business Continuity Planning, Financial Planning & Analysis, Silicon Valley.
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A number of blogs have posted a news report that an earthquake was “overdue” in Port-au-Prince – and oh, by the way, a quake should be expected in many American cities not typically associated with earthquakes: St. Louis, Seattle, Charleston, Memphis, Salt Lake City, and Boston. A FEMA report from 2001 cites additional high earthquake-risk cities (beyond the well-known ones in California): Albuquerque, Anchorage, Atlanta, Honolulu, Las Vegas, New York/Newark, Philadelphia, Portland, Provo, Reno, and Tacoma.

New York, an earthquake risk? Who new?

It makes me wonder how much business continuity planning has been done by companies dependent on at-risk locations. And more generally, to what extent vulnerability to earthquakes plays a part in company stock valuations. If it is very little, as I imagine is the case, it seems like there is a lot of room for arbitrage by the Black Swan artists. Going short on stocks of companies vulnerable to earthquakes would likely eventually pay off. Better yet, there seems to be scope for some negotiable instruments to be invented that allow investors to invest on both sides of whether an earthquake hits or not.

While facilitating such bets might seem immoral to some, in fact, such an instruments would allow a company faced with earthquake risk to hedge against this risk by buying a position that profits if an earthquake hits. Then, in the event of an earthquake, they would be able to offset their business-continuity costs (or is it incontinuity costs?) with the profit gained from the instrument.

Over the last decade, companies have become more aware of the risks posed by natural calamities, and as a result business continuity planning has arisen as a discipline. From my observations, though, those doing business-continuity planning have only been able to chip away at the edges of catastrophic risks. They’re able to do things like make sure they have redundancy in their own facilities, have multiple supply chains, and enable employees to work from home. These things are valuable, but don’t deal with the real problem of a major catastrophe in a large city which is that the surrounding area – physical and social – becomes broken, non-supportive, dysfunctional. Government services aren’t available; transportation and communication systems are broken; civil disturbances erupt; people focus on survival and stop working; residents eventually leave town.

For a company located in a hazardous zone – whether it be from earthquakes, hurricanes, flooding, etc – no amount of advanced corporate planning can overcome these challenges (except perhaps planning focused on relocation to a more benign environment). A company in the midst of a major catastrophe is stuck with negative consequences. They’re unavoidable. Business anywhere-near-as-usual, in fact, cannot continue. So, business-continuity planners have got to start thinking in different terms. Their ultimate goal needs to be, not business continuity, but rather “enterprise survival”. They need to ask questions like “how much revenue will be lost if there’s a quake and how can we make it up?” They need to think outside the box of their own organization and facilities and those of their suppliers. They need to find a way to mitigate the damages they will suffer because of what goes on outside these boxes. They need to go beyond IT engineering and civil engineering and focus on risk management and financial engineering. They need to look at concepts like markets in catastrophe-based negotiable instruments and large-scale insurance cooperatives.

This admittedly draconian view of natural catastrophes will not sit well with some, but only those who have been able to ignore the harsh reality of what has been on our TV screens: New Orleans, Chengdu, Port-au-Prince. Sure, the likelihood that your company will be hit by a calamity is low, but the consequences could be severe.

Beware: New Lease Accounting Guidelines Coming! February 2, 2010

Posted by Bob Cook in Lease Accounting.
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If the two accounting-standards boards stay on schedule, a new set of standards for lease accounting will be in place by mid 2011. The impact on corporate real estate will be BIG. And it will be SOON. Those corporate real estate execs who think these new standards are something just for the accountants to worry about risk being like a chef with his pants down stumbling around frantically trying to get his kitchen in order before the health inspector arrives.

The European-based International Accounting Standards Board (IASB) and the U.S.-based Financial Accounting Standards Board (FASB) are working together and plan on issuing a draft set of lease accounting guidelines within five months, with compliance required perhaps as early as a year later. They already issued a document last March that outlined their thoughts and which sets the general tenor of the standards.

You can see the status of the joint project, as well as links to the Discussion Draft, dated March 2009, here.

In a nutshell, each operating lease will go on the company balance sheet as both an asset and a liability, both valued at the present value of the lease payments to be made. The impact on company balance sheets will not be subtle. Many companies will have billions of dollars of new items on their balance sheet. There also will be an income statement impact as “rental expense” gets replaced with a “depreciation expense” and an” interest expense”. For corporate real estate portfolios, there will be a permanent ratcheting up of expenses related to lease payments. While the new standard is long overdue and is necessary to more accurately portray the financial condition of companies, it’s going to cause a lot of heartburn among corporate real estate execs.

The new standards are going to effect corporate real estate in four ways. First, it’s going to shine a spotlight on lease transactions and bring a lot of questions from upper managements, such as “who is responsible for negotiating these large financial obligations?” “Do they have finance backgrounds?” “Do they have a financial strategy?”

Second, at some companies, the new accounting is going to precipitate change in the internal accounting used for budgeting, internal pricing, chargebacks, and even bonuses. There are going to be a lot of food fights to see who has to eat what part of the negative soup that oozes from the new standards.

Third, except for those few companies who are confident enough to not worry about their performance as expressed by their financial statements, the new standards will change real estate finance strategy, particularly as it relates to own vs lease and the length of leases. And, interestingly, there will be no grandfathering of leases; leases written today will be re-accounted for once the standard is in place. This means new lease strategies to address the new accounting are needed today — or, actually, yesterday.

Finally, in order to comply with the new standards, companies are going to have to establish a whole new set of policies and procedures to capture the information and make the forward-looking assumptions that will be needed to account for leases. These are going to have to be SOX-compliant; they can’t be cooked up overnight.

Last fall, JonesLangLaSalle published a report citing how few corporate real estate execs had begun making preparations for the new standards. Half a year later, I doubt that the situation has changed even though the kitchen timer is ticking. In future blogs I’ll look at the reasons for the accounting changes and discuss the implications in more depth.