jump to navigation

New Lease Accounting Influences Northrop Grumman to Buy HQ July 21, 2010

Posted by Bob Cook in Corporate HQ, Financial Planning & Analysis, Lease Accounting.
Tags: , , , , , ,
trackback

Soon-to-be HQ

Today, The Wall Street Journal announced its “Deal of the Week” to be the Northrop Grumman purchase of a new headquarters building in Falls Church VA.  In “Northrop Is Flying East”, the WSJ writes that the company “looks to have gotten a pretty good deal” but that “Northrop also took into consideration the low cost of borrowing money and proposed new accounting standards that could make it less advantageous to lease real estate” (emphasis added for this post).

It is, of course, no coincidence that I’ve been proselytizing on the impact of the new accounting and that Northrop is one of my consulting clients.

Expect to see more such transactions from other companies as the impact of the accounting standards become clearer to those in corporate real estate.

Read more posts about lease accounting here.

Advertisements

Comments»

1. Richard L. Podos - July 21, 2010

Great deal and incentives, but bad decision by Northrop to deploy its own capital. I’d like to to see the projected IRR or ROI, as compared to their indicated ROC for shareholders.

By contrast, the impact of the proposed accounting will increase their D/E ratio from 0.244 to 0.248, and P&L performance by approx. and 0.04%.

Accounting should not drive economic decisions.

2. Bob Cook - July 21, 2010

Richard…

Thanks for the post… could get a lot of people’s blood going on a subject … own vs lease … that has armies of people on both sides of the debate.

Completely agree that accounting shouldn’t drive decisions, and I don’t think it did in this case. As the WSJ article said, it was one of the factors considered along with price and the cost of borrowing.

What the new lease accounting does is nudge what is sometimes a close-call decision in the direction of owning. It also removes the obstacle from owning where companies have previously categorically rejected it because they wanted to keep assets and liabilities off the balance sheet. The way i see it, the new lease accounting offers a leveller battleground in the struggle between own vs lease.

Also, while I completely agree that accounting and financial statement analysis should not drive real estate decisions, financial statements are unfortunately the only way a company can tell shareholders how it is doing financially and I really think the financial statement impact of real estate decisions do need to be considered along with the economics as represented by cashflow. The “home run” to be achieved in transaction structuring is to create a win-win transaction… one that performs well both economically and in terms of financial statement impact.

As for IRR analysis, companies vary in what they see as a hurdle rate to meet. Some look at their weighted-average cost of capital. In those cases, ownership usually doesn’t pencil out. Others look at their incremental cost of borrowing. Depending upon what is that cost and depending upon how long the company foresees needing the property, those cases can pencil out. In the case of Northrop, it’s cost of borrowing is pretty low. There are other rationales for establishing hurdle rates also. I think the hurdle-rate decision is a balance-sheet-management issue and that different companies ought to manage their balance sheets differently depending upon their industry. I might do a future post on this issue.

3. Richard L. Podos - July 22, 2010

Thanks for the thoughtful reply, Bob.

That being said:

1) Any company using incremental borrowing rate for IRR analysis of capital investments is losing money and ultimately destroying shareholder value, by nature.

2) The residual value of corporate-owned property is almost always a fraction of purchase cost, as corporates usually sell property essentially vacant, at the ebb in economic cycle.

Again, economics trump accounting.

I think, however, that the very title of this web page exhibits your thinking:

“https://bobcook1234.wordpress.com/2010/07/21/northrop-grumman-first-company-to-see-the-light-on-new-accounting-%E2%80%A6-buys-new-hq/#comments”

I should hope that economics also trump consulting revenue.

4. W. Kyle Gore - July 23, 2010

“… financial statements are unfortunately the only way a company can tell shareholders how it is doing financially and I really think the financial statement impact of real estate decisions do need to be considered along with the economics as represented by cash flow.”

Could not agree more — which is precisely why the FASB “right of use” approach is so utterly flawed, as it understates the true value a leasehold estate might have, while overstating the claim a lease obligation has against the assets of a corporation in a distress/liquidation scenario.

As you know, in a bankruptcy of the Lessee, a real property lease (as opposed to a personal property lease) is subjected to REJECTION under the Bankruptcy Code. A simplistic summary of the claim the Lessor has equates to 15% of the remains rents, with a “floor” of 1 year of rent, and a cap of 3 years of rent. Arguably, if one desires (x) a financial statement which accurately depicts what a financial statement is intended to depict i.e. the true liabilities of a Lessee, and the claims its creditors have, and (y) a long-overdue balancing between accounting and legal considerations, then FASB should be redirecting its efforts to consider the fact that Lessors (and their creditors) cannot extend claims against Lessee beyond what is allowed under the Bankruptcy Code UNLESS the related Leases are not rejected.

Ironically, in those cases where the leases are not rejected, the value of the leasehold estates to the affected Lessees logically would/should EXCEED the implied cost of the related leases i.e. the “right of use” in those cases should logically exceed the stated liability. The Kmart bankruptcy serves as an excellent example of the foregoing – leases were rejected when deemed “underwater” or operationally undesirable, and affirmed when deemed operationally critical and/or having values exceeding the related contract costs (hence, driving considerable profits to Sears/ESL in the process).

Bottom line – FASB’s proposed approach seems politically charged rather than logically grounded, may (will) serve to further obfuscate financial statements by overstating true claims against Lessees and understating true leasehold value (particularly with respect to real property leases), and provide fodder for a rise in consulting in accounting fees. Unfortunately, the stated intent – better transparency – will remain elusive.

5. Bob Cook - July 23, 2010

Kyle…

Thanks for the insightful comment. I am also troubled by the fact that lease obligations can be rejected in bankruptcy and therefore maybe should not go onto balance sheets. If one thinks the real value of balance sheets are to evaluate solvency, this view is compelling. It is important to note, though, that the lease obligations are to have their own line item on the balance sheet so it will be easy for users of the statements to consider the rejectability of leases in their financial review of a company and adjust their solvency evaluations accordingly.

As for whether the right-to-use assets will be undervalued, I think the problem you point out is a generic problem with balance sheets. Your Kmart example is interesting.. but in theory, all assets when first purchased are worth more to the compamy than what the company pays for them. Otherwise, the company wouldn’t buy the asset. So too will be the case with leases. Carrying assets on the balance sheet at historic costs (less depreciation) is a long-standing tenet of GAAP. There’s no easy way to carry assets at a value that represents value to the company.

I suppose the gist of your argument… and that of others … is that there are so many flaws in the new accounting, that it needs to be rethought…. or even killed. I think the new accounting’s supporters would agree that it is flawed, but that implementing a flawed standard is better than the present situation that provides insufficient information on leases.

6. David Ho - July 26, 2010

Rich / Bob – I agree with you in that it is unlikely the lease vs. buy financially favored the purchase, regardless if the lease was booked as capital or operating.

However, I am wondering if a purchase was a condition of the $16M incentive package and if some of these $ were available for direct building improvements. If so, these direct $ might have been enough to economically favor the buy.

Nevertheless, non-financial factors might have caused the sale such as politics, desire to own their hq building etc.

Nice discussion item!

p.s. one of my former colleagues at Verizon handled the 2007 sale.

7. Glenn Karp - September 9, 2010

Bob,

Excellent article, and very topical. Thank you for raising the impact of this accounting standard. Very interesting topic for discussion. Back to the lease vs. buy analysis. Glenn

8. It’s Time to Buy that HQ « Corporate Real Estate Strategy - October 18, 2010

[…] previously posted an article on Northrop Grumman’s decision to buy its new headquarters. Reportedly, the new lease […]


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s