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Few Comments from Lessees on New Lease Accounting as Comment Deadline Approaches December 13, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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In August of this year, FASB and IASB jointly issued an “Exposure Draft on Leases”, outlining proposed new lease accounting.  This proposed accounting differs significantly from present accounting, most notably by putting all leases on balance sheets.  The new accounting will affect both lessees and lessors.

The proposed accounting is not without controversy.  While there is no strong, informed argument against putting leases on the balance sheet, there are such arguments against some of the details of the proposed accounting … for example, the requirement to capitalize “likely” lease payments, taking into account options to renew, as opposed to just capitalizing contractual obligations.  This provision, in particular, has elicited much outrage at real estate industry forums.

The accounting boards are receiving comments on the proposed accounting until December 15, just a couple days from now.  Comment letters received by the boards are posted on their websites.  So far, a little over 100 letters have been posted.

The surprising thing: very few of the letters come from big-name companies with large lease portfolios.    In fact, by my count, only three of the Fortune 500 companies have commented thus far; only one is in the top 400 and none are retailers, whose balance sheets will be hit significantly by the new accounting.

Now, it’s possible that more companies have submitted and the boards just haven’t posted them yet, but still … three letters from Fortune 500 companies is an incredibly small number to have been posted at this late date, given the controversy surrounding the proposal.  While a slew of comment letters might be forthcoming over the next few days, one would think that companies would have wanted to get their letters in early so other companies could follow their lead, by reiterating their comments.

It appears that the corporate real estate community, which has a strong stake in the outcome of the new accounting, has not been very successful in getting companies to raise the points of concern that have been the subject of industry forums.   Was it lack of true concern?  Inability to influence within the corporation?  Unfamiliar terrain?

To see my previous posts on the new accounting, including my recommendations for comment letters, click here.

Implicit Leases: The hidden bombshell in FASB’s new lease accounting December 5, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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As we approach the December 15th deadline for commenting on FASB’s and IASB’s “Exposure Draft on Leases”, I thought I’d point out a far-reaching implication of the new lease accounting … an implication that has gotten surprisingly little attention.  It’s this: the new standard applies to not just explicit leases, but also to implicit leases.

Now it should be obvious that just because a contract explicitly says “Lease” in its title, does not mean that it is a lease … for any purpose, let alone accounting.  Also, conversely, a contract that does not say “Lease” in its title is not necessarily not a lease.  Under lease accounting, if a contract is or contains an implicit lease for accounting purposes, it’d have to be accounted for, in whole or in part, as a lease.

What-you-don’t-think-is-a-lease but which is a lease in terms of accounting, may surprise you.  The accounting definition of a lease does not conform to any layman’s definition or, for that matter, to any legal definition.  For  example: some types of licenses that give a company the right to occupy space, perhaps as part of a larger contract, are likely to be deemed to be leases for accounting and have to be accounted for as such.   In addition, the new accounting will also apply to service contracts involving equipment, such as photocopy machines.

The implicit-lease issue goes, though, far beyond licenses and equipment-based service contracts.  It will apply to some subcontracts and outsourcing arrangements … contracts that the contracting parties undoubtedly do not now think of as leases.

How’s that?

Appendix B of the Exposure Draft provides the proposed accounting definition of a lease.  It says, in essence, that each and every contract a company signs needs to be evaluated to see if it is or contains a lease.  If the following two characteristics are present, part or all of the contract must be accounted for as a lease:

(a)    the fulfilment of the contract depends on providing a specified asset or assets and

(b)   the contract conveys the right to control the use of a specified asset for an agreed period of time.

The document goes on to provide guidance in addressing these two tests, and you should read this guidance to understand the nuances.  Regarding these two tests as it relates to buildings, (a) a building would be deemed to be specified if the supplier was not able to relocate production to another facility without the customer’s approval, and (b) the building would be deemed to be under the control of the customer if the customer got all but an insignificant amount of the benefit from its use.  While contracts that call for payment on a unit-price basis would probably not be deemed leases, there will still be some types of sub-contracts and outsourcings that will be deemed to have implicit leases embedded in them. 

Consider a contract where Company A outsources logistics to Company B for a period of time and agrees to pay a certain amount each month for the service.  If Company A gets to say in which of Company B’s facilities this work is done and if the work Company B does in that facility is almost all to service Company A, then it is very possible that a portion of that contact will be deemed to be an implicit lease.  The obligation related to that portion would have to be capitalized and put on Company A’s balance sheet; Company B would account for that portion of the contract as a sublease.

This is going to take a lot of companies by surprise, and has an ironic twist.  One of the motivations for many companies who have outsourced work previously done in-house has been the ability to get assets (and related liabilities) off their balances sheets.  Well… surprise, surprise!  Those assets and liabilities may be coming back as a result of the new accounting.

The implicit-lease issue could even hit parts-supply contracts where conditions (a) and (b), above, exist and contract pricing is on a cost-plus-profit basis.  It also may hit energy contracts where a third party installs energy-saving or power-generating equipment, such as solar panels, on a customer’s site and then sells the power to the user.  This could have a big effect on the business models of such third-party suppliers of energy.

In truth, the need to evaluate whether a contract contains an implicit lease is not new; it already is an accounting principle.  Heretofore, though, unless an implicit lease met the conditions that made it a capital lease (which would then have to be put on the balance sheet), the identification of a contract as being or containing an implicit lease was non-material.  This is because operating leases and service contracts have been accounted for similarly … both off-balance sheet.   The “implicit lease test”, therefore, tended not to be applied rigorously.  Now with the new lease accounting putting leases on balance sheet, though, the test as to whether a contract is or contains a lease is far from immaterial.

The implication of applying the new lease accounting standard to implicit leases could be vast.  In theory, every contact signed by a company will have to undergo a “lease test”, just like today every lease needs to undergo a “capital lease test”.  Think of the process implications.  And beyond that, think about how your company might have to re-think strategies surrounding outsourcing and supply-chain management.  This is yet another reason that the new lease accounting has implications far beyond what most people think.

Lease accounting isn’t just for real estate, anymore … and it’s not even just for the-contracts-you-thought-were-leases, anymore.

Click here for more posts on the new lease accounting.

Comments to FASB on Lease Accounting – My Recommendations November 7, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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Like every vote, every comment counts.

This past August, the U.S.-based Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued the ”Exposure Draft on Leases” which details how the two accounting boards think lease accounting should work.   The Boards will accept comments on the new standard until December 15, 2010 with comments to FASB being shared with IASB, and vice versa.  The two Boards plan to jointly issue the final standard by the end of June 2011.

The thrust of the new accounting is to put  all lease obligations (with some minor exceptions) on company balance sheets (along with an off-setting “right of use asset”).   Most knowledgeable observers agree that leases, which today represent some of the largest obligations of companies, need to be on balance sheets … if balance sheets are to be  meaningful.  Comments to FASB that oppose the fundamental principle of putting leases on balance sheets are likely to be considered uninformed.

As they say, though,” the devil is in the details”.  Leases are sufficiently complex that accounting for them requires a lot of detailed, sometimes devilish, rules, and there are details of the proposed  accounting that merit comment .   In fact, the Exposure Draft lists nineteen questions that the accounting boards are interested in hearing comments on.

As I’ve noted in a previous post, though … while there are many effects of the new accounting that may be seen as undesirable, either because they cause a large administrative burden or negatively affect P&L statements in ways that don’t seem intuitive,  this, itself,  is not a legitimate reason to comment to FASB.  Only comments that respect existing accounting principles and suggest a better way to account for  leases are likely to be seriously considered.   There is no use in making comments that are uninformed.  Said another way: “No belly aching”.

The new accounting affects companies on both sides of a lease transaction, and no matter what your perspective … tenant, landlord … equipment lessee, equipment lessor …  outsourcer, contract manufacturer … there is probably a lot to not like in the new accounting.  You’ll want to review the Exposure Draft carefully to see if your company has any idiosyncratic situations that would be affected by the new accounting in ways not intended by the accounting boards. Those special situations might merit comment and might prompt FASB and IASB to modify the proposed standard to avoid unintended consequences.

There are, though, controversial elements of the new accounting that will affect everyone applying the new standard, and these merit comment from you.   From a corporate-real-estate perspective, I believe two elements of the accounting rise to the top of concerns.  Here they are:

Concern #1:  Longest possible lease length more likely than not to occur

The accounting detailed in the Exposure Draft requires tenants to evaluate the likelihood of their exercising options-to-renew (and also, presumably, options-to-expand).  A company would then place onto its balance sheet the future obligations related to the “longest possible lease length more likely than not to occur.”  If you’re likely to renew a lease with an option to renew, you would include the obligations during that extension period in the amount that goes onto the balance sheet.

Most tenants will not like this element of the new accounting … that is including obligations related to the extension period … because it will increase the amount that goes on the balance sheet.   Companies, in general, will want to minimize that amount because the higher the amount of liabilities shown on a company’s balance sheet, the riskier will the company look to investors.  

The proposed treatment for leases differs markedly from how “capital leases” (or “finance leases”) are accounted for today.  Presently, capital leases go onto balance sheets but only in an amount equal to the company’s contractual obligation (albeit, including renewal periods where exercise of a bargain-renewal-option is reasonably assured.) 

Reportedly, the accounting boards want obligations related to extension periods on balance sheets because they fear that tenants would otherwise be able to hide obligations by writing short leases with multiple renewal periods.  The truth is, though, such “structuring around” the lease accounting is easier said than done.  The economic motivations of lessors would, in fact, prevent this from happening.  Lessors are usually not indifferent to having a long lease versus a short lease renewable at the tenant’s option.  If this is the Board’s concern, it seems unfounded.

It seems to me that lease obligations that go onto the balance sheet should be only those amounts for which a company is contractually obligated, plus those related to bargain-renewal-options.   That is, after all, all that they owe.   If a bargain-renewal-option does not exist, then obligations related to extension periods should not go on the balance sheet.

Issue #2:  Effective Date.  

The Exposure Draft calls for a tenant to “apply this guidance in its annual financial statements for periods beginning on or after” the Effective Date.  If, for example, the Effective Date were January 1, 2012, then a company’s first annual report after that date would have to comply … whether that report was issued on January 2nd or December 31st of 2012. 

For now, the Boards have left the Effective Date blank, but they have their task cut out for them in filling in that blank.

Debate about when should be the Effective Date will be lively.  On one side will be those who want balance sheets to be made meaningful ASAP; on the other side will be those who are worried about how long it will take companies to comply with the new standard.

Most companies do not presently collect all the information and assumptions related to leases that they will need in order to comply with the new standard.  In fact, many companies do not even have an inventory of leases that they could vouch as being accurate enough to be the basis for the amounts that will go on their balance sheets.  Companies have quite a bit of work before them to be ready to comply.

Moreover, IT applications don’t even exist yet to easily collect the required lease data and assumptions, to manipulate that data, and to export it to financial accounting systems.   Software suppliers are unlikely to put significant resources into developing such applications until the standard is finalized, and it could take them a year or longer before their new applications are ready for market.

Making matters even worse, the standard calls for companies to use a “simplified retrospective approach” to transition to the new standard.  To do this, companies will have to have data stretching back two to three years prior to the Effective Date for existing leases.  They’ll also need data on leases that have expired within the two or three years prior to the Effective Date.

The “simplified retrospective approach” is a compromise offered to the two sides of the aforementioned debate.   Those wanting the most meaningful balance sheets ASAP would prefer a “fully retrospective approach”.  That would have required companies to go all the way back to the inception of every existing lease and recreate what the accounting would have been over the years if the new standard had been in place.  The Boards deemed the cost of that approach to not be worth the benefits.  Those worried about the cost and difficulty of compliance would have liked existing leases to be grandfathered and for the standard to only apply to new leases.  This would be a “prospective approach”.  The Boards rejected this as not treating all leases the same and as an approach that would take many years before existing leases expired and all leases would be accounted for under the new standard.

The middle ground that is proposed, the “simplified retrospective approach”, calls for leases to be treated as if they are new leases at the time the new standard is applied.  The rub, though, is that the new standard has to be applied at the “date of initial application” which is the “beginning of the first comparative period presented in the first financial statements in which the entity applies this guidance.”   Most companies present in their annual financial statements, for comparison purposes, financial statements for the two prior years.  This means most companies will have to begin applying the new standard three years prior to the date they first issue financial statements using the new standard.  It’s three years because they need to apply the standard to the year that is the subject of the financial statements plus the two prior years.

That means, if the Effective Date were January 1, 2012 and if a company issued annual financial statements for the year ending, say, March 31, 2012, then the company would have had to apply the new standard way back on April 1, 2009.  That was over a year ago.  What company still has all the data around that it will need to go back and apply the standard at such an early date?  You can see the problem.

It would be unreasonable to require companies to apply the standard to a date prior to the issuance of the standard.  So, if the standard is issued on June 30, 2011, then the Effective Date shouldn’t be until June 30, 2014.  And since companies deserve to have a little bit of runway before they need to start the accounting, my recommendation is a date of December 31, 2014, in which case the standard would have to be applied no earlier than January 1, 2012.

This Effective Date is going to be hotly debated.  My suggestion means that some companies will not issue statements using the new accounting until they issue statements for fiscal years ending December 31, 2015.  Those won’t actually be issued until early 2016.  Some may think this is way too long to wait for balance sheets to become meaningful.

Your Comment Counts

It’s like voting.   Every comment counts.  Don’t miss the deadline:  December 15.  FASB and IASB are awaiting your comments.  Mobilize your company to prepare and send one, NOW!

There are other sources of recommendations for comments you might check out.   A group of members of Corenet Global have prepared a good document to guide you.  If you are a Corenet member you can access it from the homepage of Corenet’s Strategy and Portfolio Planning Community here.

See my other posts on lease accounting here.

Start preparing your comments on FASB’s Exposure Draft on Leases October 24, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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When FASB and IASB issued their Exposure Draft on the new lease accounting, they solicited comments from interested parties.   Anyone can comment about anything.  Just know, though, that comment letters are posted on the websites of the two accounting boards, and you don’t want to have foolish comments up there for everyone to see.

(As an aside: I don’t know what policies the boards have regarding inappropriate comment letters they get.  Will they post those that are off-topic or those that are obviously uninformed?  And what about those, if any, that are obscene?  Given the outrage shown by some corporate real estate folks, I wouldn’t be surprised if a letter or two shows up with some salty language in it.)

Click here for past posts on the new lease accounting.

Comments due December 15, 2010

December 15th, the due date for comments, isn’t that far away.  While you can comment about anything, the boards have released 19 questions that they’d like comments on.  These range from the conceptual, e.g. “Do you agree that a lessee should recognize a right-of-use asset and a liability to make lease payments?”  (Question 1) to the technical, e.g. “Do you agree that a lessee should present liabilities to make lease payments separately from other financial liabilities?” (Question 12)

What should real estate professionals comment on?

While the accounting boards will accept comments from anyone, including trade organizations and consultants, they are most keen to hear from those who use financial statements and from those who will have to apply the standard to prepare their financial statements.  For the latter, preparing a comment letter will usually be the responsibility of the technical accounting department and corporate real estate people will have to work through it to get their voices heard.

Corporate real estate folks need to understand, though, that many of the questions posed by the accounting boards cannot legitimately be commented upon by anyone who does not have a strong understanding of accounting and its role in facilitating information flow in the business community.   Comments that appear to come from those unschooled in accounting principles are likely to be dismissed.  Corporate real estate folks need to avoid wasting energy making comments that are uninformed.

Also, corporate real estate professionals need to understand that there may be elements of the new accounting that they don’t like but which are based on long standing accounting practice…. and objections to these will likely be considered uninformed and will not sway the boards’ opinioins.  For example, many corporate real estate folks are concerned about how the imputed interest on the lease liability is to be calculated.   The new standard calls for use of the “interest method” (as opposed to something like a straight-line amortization of the total interest charge.)  For sure, this is going to have some painful results in the form of high P&L expense in the early years of the lease… particularly for very long leases.  Nevertheless, it is naïve to expect that a special type of interest accounting should be allowed for leases.  The principle for how to account for imputed interest is already well established and, in fact, is already applied to real estate where capital leases are involved or where FAS 146 reserves have been established.  The boards are not going to allow a new form of calculating imputed interest for leases just because it will be painful.  The present imputed interest methodology is sound.  In fact, conceptually it makes sense for companies to feel a little more P&L pain in the early years of the lease; that’s when they are getting the greatest benefit of controlling an asset far into the future.  The “interest method” of computing interest is an established accounting principle; that’s why the interest calculation is not among the 19 questions that the accounting boards have put forth for comment.  I don’t think it’s up for debate.

The 19 Questions

A good guide as to how to avoid making uninformed comments is to only make comments that respond to one or more of those 19 questions.  The people who work at the boards are pretty smart.  They understand which elements of their proposal cause heartburn and where they might be able to make adjustments without conflicting with existing accounting theory and practice.  They’re actually really interested in hearing suggestions for alternative accounting treatments that can avoid the heartburn, at least as long as the suggestions don’t fly in the face of long-held accounting principles.

Here are links to the Exposure Draft so you can read the 19 questions for yourself.  They appear near the beginning of the Exposure Draft.

Click here for U.S.-based Financial Accounting Standards Board’s (FASB’s) version.

Click here for International Accounting Standards Board’s (IASB’s) version.

In future posts, I’ll provide my thoughts on each of these questions.

Click here for past posts on the new lease accounting.

Three facts that compel you to tackle the new lease accounting NOW October 17, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.
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A lot of corporate real estate people have not yet begun tackling the challenges brought on by the new lease accounting.  You may be one of these.  You may think this new accounting is something that won’t affect you … that “accounting” happens downstream from your decision-making.  Wrong!   It’s going to rock your world … from how you strategize to how you manage.   Or, you may be one of those waiting for direction from your finance / accounting department, having been told … admittedly, correctly so … that the standard hasn’t even been finalized yet.   “Danger, danger!”  Maybe you need Will Robinson’s robot to warn you about what is just around the bend.  And don’t you watch action movies?  Don’t you know the bomb squad doesn’t wait until the existence of the bomb is confirmed before they spring into action?   Maybe you’ve been lulled into non-action because you’ve been told the Effective Date won’t be until 2013 or 2014, and therefore, you think you have plenty of time to address the issues.   Well, shame on your finance group, if they haven’t also told you about the comment period that ends in two months.  And double-shame, if they haven’t briefed you on the details of the accounting and its transition rules, particularly if they haven’t explained to you the meaning of:  “no grandfathering” and “retrospective application”.

Now, to be fair, the standard isn’t finalized and you might not want to “pull out all the stops” yet to address it.  There’s even a chance … ever so slight … that the standard, due out by end of June 2011, will be postponed… perhaps even indefinitely.   Still, there is plenty to get started on to prepare for its issuance.  In fact, what you should get started on is too much to list here…. but I’ll outline it in a future post.

While some of the details of the standard, as outlined in the Exposure Draft of August 2010, may be changed, the issuance of the standard, in a form close to that outlined, is pretty likely.  After all … the creation of this new standard has been in the works for several years and has followed a deliberate, rigorous process that included issuance of a Discussion Paper way back in March, 2009.  That paper outlined the general thrust of the standard … that all leases would go onto the balance sheet … and it solicited comments … pro and con …from companies and other interested parties.   Three-hundred comments were received … some supportive, some not.  The non-supportive ones did not persuade the FASB and IASB to change course.  The momentum to establish this new standard is strong.  Its issuance is not inevitable, but it’s very likely.

Now is the time to get cracking on this.  There are three facts that compel you … if you are involved in corporate real estate … to address the new lease accounting now:

Fact #1:  Comment Deadline.   December 15, 2010 is the deadline for interested parties to comment on the standard as outlined in the Exposure Draft.  Anyone can comment.    Corporate real estate execs should get involved.

It’s appropriate that comments made to the FASB and IASB come from finance departments who have the technical background to understand the nuances of the standard and to communicate their concerns in accounting language.  The finance department probably does not, however, understand how difficult it is going to be for the corporate real estate department to supply the type of data that the new accounting requires.  The corporate real estate department needs to share its perspective, particularly because that perspective will inform what-is-probably the most controversial aspect of this new standard … and that is the cost-benefit of the standards application.  Much of the cost … in terms of both out-of-pocket costs and demand on management time … will be borne by the corporate real estate department.  The finance department cannot address the cost-benefit question without input from the corporate real estate department.

Now, some corporate real estate execs may take the view that they don’t need to get personally involved because comments to the FASB and IASB from larger companies, with more resources to devote to comment letters, will cover the same concerns they would bring up.  Besides the fact that this is like a citizen deciding to not vote because he thinks his one vote can’t make a difference, there is a big problem with relying on the comments of others.   Every company is unique.  Your company may have special contractual situations that may be inadvertently affected by the new lease accounting.  You should know that the new accounting applies not just to explicit leases, but also to implicit leases.  A document doesn’t have to say “Lease” in its heading to be a lease.  Every company should be looking at its business model to see where this new accounting might apply.  Many companies are going to be surprised to find how it can apply to things like outsourced manufacturing, CoLocation datacenter contracts, and on-site solar energy contracts.  Some of these will be sorry they didn’t comment on the impact on their special situations.  Don’t you be one of these.

Fact #2:  No grandfathering.    It is almost 100% assured there will be no grandfathering of existing leases.   If existing leases were not put on the balance sheet at the time the new standard is applied, the balance sheet would become meaningless.

So… many leases being signed today will eventually fall under the new accounting.  And it won’t just be leases with expiration dates beyond the time when the standard will be put in place.  It will also be leases that expire sooner but that have options to renew for periods that go beyond the effective date.   Most sizeable leases would fall into one of these two categories.   If you are not already looking at these leases … and the relevant issues such as lease-vs-own and length of lease … through the lens of the new leasing, then shame on you.

Fact #3:  Retrospective application.    When companies first issue financial statements using the new standard, there will be a need to include prior-year comparison statements so investors can make year-to-year comparisons on an apples-to-apples basis.   Most companies will show two years of prior statements in what-the-FASB-and-IASB-call a “simplified retrospective approach”.   If you think through the timeline, you’ll quickly see that you may already need to begin collecting the required lease information, lest you end up having to scramble in three years to reconstruct what your lease data was three years prior.  For example, an Effective Date in 2013 would mean you need to have data to prepare 2011 financials using the new accounting and, in order to do that, you’d need information going back as early as 2010.  (Yes, that’s NOW!)  Unless you’re different from most companies, you  probably are not now collecting all the data points that will be needed for the new accounting.  If you don’t start now, you’ll have a huge headache later.

So, if you are one of those corporate real estate folks who have postponed addressing the new accounting because you are skeptical that the new lease accounting will have much effect on you … for example, if you don’t agree with the opinion that the spotlight it puts on corporate real estate is likely to transform the profession and what-is-expected of you … then, at least, these three facts should stir you into action.

FAS 13 and IAS 17 soon will both be history.  Learn more about the new lease accounting here.  If you’d like to follow my posts, click on the “subscribe me” on the side bar.

For-Profit Education and the Need for Leases on Balance Sheets September 12, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.
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September’s here, school is starting, out-of-work workers need retraining … and the for-profit education industry should be partying. Shareholders and managers of companies running places like University of Phoenix (APOL), Argosy University (EDMC) , Corinthian College (COCO), DeVry University (DV), Strayer University (STRA), and others should be having back-to-school beer busts. Events of this past summer, though, have dampened the industry’s prospects, and a sobering time is ahead.

Until recently, the industry had been on an expansion tear, as the unemployed and underemployed attempt to upgrade their credentials in a challenging job market. Fortune’s “100 Fastest-Growing Companies” lists DeVry (#46), Strayer Education (#74) and Corinthian Colleges (#79). This summer, though, the U.S. Department of Education announced that it wants to curtail access to federal funds for any for-profit education company where too many of its students don’t repay their college loans … particularly if the non-repayment is due to the fact that there’s no way their students can earn enough after graduation to make payments. As you might guess, the DOE action was prompted by its discovery that, in fact, this is the case for many companies in the sector. As a result, the future of these companies is suddenly in jeopardy. If their students can’t get government-supported student loans, enrollment will fall because many prospective students won’t be able to pay tuition. Fewer students will mean, of course, less revenue.

How will these companies fare? If you look at just their financial statements, you’d get the impression that the companies are so under-leveraged that they will easily be able to survive reduced revenue. The Apollo Group, owner of the ubiquitous University of Phoenix, with annual revenues of $4.8 billion and net income of $600 million, has only $350 million of long-term obligations. Another example: DeVry has annual revenue of $1.9 billion, net income of $280 million, and long-term obligations of only $106 million. A third example, particularly eye-catching: Strayer has annual revenue of $579 million, net income of $120 million and a measly $12 million of long-term obligations. All of these companies could pay off their long-term obligations, as shown on balance sheets, with only a portion of one year’s earnings.  Across the industry, financial statements make companies look strong.

Undoubtedly, some investors have bought the stock of for-profit companies thinking the companies offered a great combination of fast growth and strong financial structure … a combination that they could have known was too-good-to-be-true if only they had read the notes in the companies’ financial statements filed with SEC.

They would have, though, had to have read those notes very carefully … and thoughtfully … and knowledgeably … and not have overlooked the section on operating leases. The operating lease section is just one of many in the “Notes to Consolidated Financial Statements” included in 10-K submissions. These notes are generally intended to provide detailed information on the line items shown on the balance sheet and other financial statements. In the case of the operating lease section, however, information is about obligations that don’t appear as line items on the financial statements. Anyone without an accounting background could easily overlook the import of the section. And many probably have.

The truth is these for-profit education companies have hundreds of millions of dollars of operating lease obligations which are all “off-balance sheet” even though are as real as obligations like the bond debts which are “on-balance sheet”. In the case of Apollo, there are $757 million of future lease obligations … more than twice the amount of long-term obligations now shown on the balance sheet. At DeVry, future lease obligations total $579 million … more than five times the amount of long-term obligations shown. And at Strayer, future operating lease obligations total $218 million, which is … OMG! … more than 18 times (yes, that’s eighteen times, no decimal point is missing!) more than the amount of long-term obligations shown on the balance sheet.  (See Table A.)

Table A: Stats for Selected For-Profit Education Companies   (in $ millions unless otherwise noted, rounded to simplify presentation)

Annual Revenue (1) 4,800 2,000 1,800 1,900 2,500 1,500 580
Annual Net Income (1) 600 210 150 280 170 350 120
Long-Term Liabilities (2) 350 200 400 100 1,930 175 12
Future Operating Lease Obligations (2) 760 725 635 580 1,140 185 220
Lease Obligations As % of Long-Term Liabilities 217% 362% 159% 580% 59% 106% 1833%

Note 1:  Last twelve reported months.   Note 2: Last annual 10-k report.

If these operating lease obligations were included on balance sheets, investors would get a much better idea of the financial structure of the companies. They would understand how these companies have funded their operations with operating leases, which is not necessarily bad, but it does mean that these companies are not as financially secure as financial statements would lead one to believe.  These leases represent high fixed expenses that put these companies at solvency risk should their revenue decline. If all leases were on the balance sheet, investors would understand that these companies are, in fact, highly-leveraged … via operating leases.

And while it is true that, in the case of a bankruptcy filing, a company may have the right to cancel leases such that, theoretically, operating leases are less set in concrete than are obligations like bonds, from a practical point-of-view, how can a company actually cancel leases and improve its situation?  Any wholesale canceling of leases would be tantamount to going out of business.  So while leases might, legally-speaking, be canceled, this is a mute point, practically-speaking.

And so we have a situation where the largest obligations of these for-profit education companies do not appear on their balance sheets even though balance sheets are supposed to provide a snapshot of a company’s financial situation, showing what it owns and what it owes. Balance sheets aren’t doing what they’re supposed to do. And while savvy stock analysts understand that lease obligations are not on the balance sheet but can be seen in the notes to the financial statements, even some of them probably don’t fully account for these obligations when evaluating companies.  And they probably don’t go out of their way to bring these obligations to the attention of investors when things are booming and they have a “buy” recommendation out.  For many reasons, obligations noted in footnotes just don’t carry the same weight as those seen on balance sheets. Out-of-site, out-of-mind.

So what should be done?

Well, what should be done is being done… albeit, belatedly. The FASB and the IASB are working together to create a new accounting standard for leases. The proposed standard is outlined in the Exposure Draft on Leases issued by the two accounting bodies in mid-August. The thrust of the new standard is that leases will go onto the balance sheet … as both a right-to-use asset and a lease liability … in an amount equal to the present value of likely lease payments. This proposal is open for comments until December 15, 2010, and the accounting boards plan on issuing the new standard by June 2011.

Many people aren’t enamored with the proposed new accounting. It is going to cause a lot of pain to companies in terms of the effort required to comply and has many implications that reach far beyond accounting, per se.  

The case of the for-profit education industry, though, shows how important lease-accounting change is if financial statements are to serve their function. This will become all the more clear if revenues of these for-profit companies decline, and one or more of them file for bankruptcy protection.  If this happens, the for-profit education sector will serve as “Exhibit A” in the argument for why leases should go on balance sheets.

Click here to read more posts about the new lease accounting.

For your self-preservation, Mr Corporate Real Estate Exec … September 2, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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Regarding the new lease accounting, Mr. Corporate Real Estate Exec, you really shouldn’t be waiting to get direction from your accounting folks. You need to understand the implications of this new standard now and begin making preparations to comply. 

The Exposure Draft on Leases was issued by IASB and FASB in mid-August. Your company’s technical accounting folks are probably reviewing it, digesting it, and starting to think about its implications for the company financial statements and for its accounting processes. Their world is different from yours, though … and you can’t expect them to anticipate and address the challenges you will be facing as a result of the accounting change. You need to address this thing yourself; get ahead of it … before it gets ahead of you. 

Your accounting folks will be quantifying the impact of the accounting on company financial statements. They’ll not, though, be worrying about how it’s going to affect your real estate budgets and how you’ll have to change formulas for allocating expenses to business units. Your accounting folks will be preparing process diagrams showing how the accounting processes will flow once they get the required lease information from you. They’ll not, though, be worrying about how you meet the challenge of assembling, recording and providing all that information in a SOX-compliant manner. Your accounting folks will see and maybe advise you on how the structure of real estate transactions affect the financial statements. They’ll not, though, be the ones who will have to justify the structuring decisions you are making today … decisions that will suddenly affect company financial statements when the accounting is adopted because there will be no grandfathering of existing leases. 

The heavy-lifting in terms of compliance (not to mention, the managing of implications for real estate strategy) is going to be done by corporate real estate departments, not accounting departments. You’ll have to design new SOX-compliant processes to record lease information (much of which is not now in lease administration systems) and to make assumptions about future needs. You’ll have to implement new IT systems or at least enhance your existing systems. You’ll have to revamp your charge-back systems and communicate that change to your internal clients. You’ll have to audit your present lease information for completeness and accuracy. You’ll have to hire and train people, or engage service-providers, to manage the new processes, input data, and collaborate with the accounting department.  

Yes, this accounting change is going to pose major challenges for you, Mr. Corporate Real Estate Exec. It may be soothing to think that you can wait to hear from your accounting folks on this issue before taking action, but you do so at your own peril. The challenges are many and the time available to comply, while not yet prescribed by the accounting boards, is likely to be much less than what you’ll think you need. The sooner you start, the more time you’ll have.  

Don’t be one of the corporate real estate execs … and there will be some … who don’t address this until their accounting department gives them direction. Here is what will unfortunately happen in many situations: The accounting department will eventually issue a list of lease data that the corporate real estate exec will have to provide. Not knowing, though, how difficult it is to assemble and record this information, the accounting department will not issue the list until there is insufficient time and industry resources to put the data-assembly-and-recording processes and systems in place before the standard must be adopted.

That situation … a career-killer, if ever there was one … is not one you want to find yourself in.


Click here for more posts on the new lease accounting.

Ten Things You Need to Know about the New Lease Accounting Standard August 23, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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The “Exposure Draft on Leases” issued by FASB and IASB on August 17, 2010 is 66 pages of sometimes dense reading. I thought people might like a succinct  summary of what’s in it and what are its implications. At the risk of over-simplifying something that is pretty complex, here it is in ten little bites, starting with the main driver of the change … namely, the desire to make lease obligations more visible to investors by putting virtually all ….

Leases on Balance Sheets. (#1)   The present value of virtually all lease obligations will go on balance sheets in two places: as a “right-to-use” asset on the “left side” of the balance sheet and as an offsetting “lease liability” on the “right side”. This will not, though, be a simple calculator exercise; judgement will be required because the amount to be capitalized will be based on ….

Likely” Obligations, not “Minimum” Obligations. (#2)  The amount that goes onto the balance sheet is based on the “likely” lease obligation, taking into account factors such as the likelihood of exercising options to renew and the likely payments to be made as contingent rents. The need to make assumptions about options, contingent rents, foreign exchange rates, future market rental rates and the like, is going to lead to a lot of ….

Auditor Scrutiny. (#3)   Auditors will feel compelled to closely watch the assumptions used in calculating the amounts that go onto balance sheets. Where there are assumptions in accounting, there is room for manipulation. Most companies will want to make assumptions that minimize the amounts that go on balance sheets, and auditors will be watching for things like unsubstantiated claims that options to renew are unlikely to be exercised. They’ll also be scrutinizing the accuracy of P&L accounting for leases as that accounting becomes more complex as a result of the change to ….

Amortization and Interest Expenses Instead of Rent Expense on P&L. (#4)  Instead of a rent expense, companies will experience an amortization expense related to the right-to-use asset and also an interest expense related to the lease liability. The latter will be higher in the earlier years of the lease than in the later years, and therefore, so too, the total expense associated with a lease will be higher in the earlier years than in the later years.  Moreover and importantly, this total expense will be higher in the early years than what it would have been under existing accounting … and this will, when the new standard is first used, lead to ….

Busted Budgets. (#5)   Transition rules require that existing leases on the day that the new standard is applied will be accounted for as if they were new leases.  Therefore, in the early years of the application of the new accounting, virutally all leases will have a higher P&L expense associated with them than they would have had under existing accounting.  Most companies will experience an increase in lease expense of from 5% to 10% just due to the accounting.  This ratcheting up of lease expenses is going to reverberate throughout companies and have numerous ….

Downstream Effects. (#6)  The new accounting for leases will have many consequences, affecting everything from corporate and business unit budgets (and people’s bonuses!) … to real estate charge-back methodologies … to financial statement performance metrics … to compliance with bond and debt covenants … to cost-plus contract pricing.  In addition, the new lease accounting has important ….

Strategic Implications. (#7)  Three areas of strategy will be greatly affected. First, own-vs-lease decisions take on a new complexion as leases, particularly long leases, become undesirable. Second, lease duration becomes a more important decision putting the financial statement benefits of “going short” at odds with the desire to control space and lock-in current rental rates that can be had by “going long”. Third, longer-term consolidation planning takes on new value if it can substantiate assumptions that exercising of options to renew are unlikely. It is going to be crucial for companies to address these strategic implications, but it may be difficult for them because so many resources are going to be tied up dealing with ….

Compliance Complexity. (#8)  Most companies do not now have the processes, systems, personnel, and databases to comply with the new standard. A huge amount of work will be involved in establishing all of this infrastructure, and doing so will be challenging and complex because the infrastructure will need to transcend intra-company boundaries. This is why there is still uncertainty about when will be the standard’s ….

Effective Date. (#9)   The IASB and FASB plan on issuing the final standard by June 2011, but compliance will probably not be required immediately. It will be difficult for companies to put in place the infrastructure to comply and comments to that effect are likely to be made to the accounting boards during the Exposure Draft comment period which goes until December 15, 2010. Most observers think the boards will set the Effective Date for sometime in 2012 or 2013. That does not mean, though, that companies have the luxury of waiting before they address the new standard. There is much for them to do to get ready to comply. More importantly, though … from a strategic-point-of-view … the standard is already “in play” because there will be ….

No Grandfathering. (#10)  On the date that a company begins using the new standard, all existing leases will go onto the balance sheet as if they were brand new leases on that date. That means that leases being signed “today” will be subjected to the new accounting and that lease decisions being made “today” need to be viewed through the lens of the new accounting … which leads to my ….

Closing thought.  If you’ve not yet formulated your company’s response to the new lease accounting … by reviewing your real estate strategy and modifying it, as necessary … by revamping your decision-making framework and tools to incorporate the new accounting … and by laying out how you’ll go about planning and implementing the infrastructure needed to comply … then, you’re already behind.

A good way to learn more about the new accounting is to read my other blog posts on the new lease accounting where I’ve dealt with the strategic and practical implications of the new standard. You can easily follow my future posts by subscribing to the blog via email (which you can do on the right side bar).  You can also check out the webinar series on “The New Lease Accounting Standard and You” that I held for TRIRIGA and which is still available on-demand, or alternatively, read my companion white paper published by TRIRIGA.

Exposure Draft on Lease Accounting Is Out August 17, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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Today,  IASB and FASB issued the long-anticipated Exposure Draft on lease accounting.   While the ED is a few weeks later than originally anticipated, the target date for the issuance of the new standard remains June 2011.

Comments from interested parties will be received up to December 15, 2010.

You can view the ED here.

And you can view my previous posts on the new lease accounting here.

My White Paper on the New Lease Accounting Is Available August 9, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.
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If you register on the TRIRIGA website, you can get access to my white paper “The New Lease Accounting Standard and You” here. Like the TRIRIGA webinars that I’ve held, the paper will inform you about … not just what the new standard will be, but … what the strategic and process implications are for those involved in corporate real estate.

If you’d like to hear the webinars, they are also still available, on-demand, on TRIRIGA’s website here. If you have time to listen to just one of the three, I’d recommend the second webinar entitled: “Strategic and Practical Implications”. I’ve had many people tell me that they found the webinars very illuminating.

BTW, FASB and IASB are expected to issue the Exposure Draft on Lease Accounting this week.   There probably won’t be too much new in the document for those who have read the previously-issued Discussion Draft and who have followed the accounting boards deliberations over the last few months … but the issuance of the Exposure Draft should spur companies to get serious about addressing how the new accounting standard is going to affect their real estate strategies and processes.   See my previous posts on the New Lease Accounting, here.