The great thing about people who represent an industry being affected by an accounting standard is that they are highly motivated to provide content.  Bill Bosco sent me a number of files for this week’s Roundtable.  The ELFA comment letter on leasing discusses both lessor and lessee accounting, and objects strongly to the notion that lessors are engaging in a service activity; more generally, they oppose constraining new leasing standards to fit into more general models (like revenue recognition). More pointedly, they express concern that capitalizing all operating leases will have a big effect on the bottom line:

Lease costs will rise by more than 20% in the first year for many of the companies and the front ending effect can last for as long as 20 years until the lease cost reaches steady state where the back end costs of old leases offset the front end costs of new leases. The cumulative amount of increased lease costs will be a huge drain on capital – the amounts for a large retailer or bank will be in excess of one to two billion dollars.

In this CFO Magazine article, Bill Bosco clarifies that analysis:

The proposed rule will capitalize the former operating leases which are currently not reported on balance sheet for lessees. The new approach creates a large non-cash expense, in which the amortization of the right of use (ROU) capitalized lease asset plus the recognition of imputed interest expense on the capitalized lease obligation exceeds the cash paid for rent in the first half of the lease term. It is a timing difference in which the lease expense is higher than the cash rent paid in the first half of the lease, but the pattern “turns around” in the second half of the lease where lease cost is lower than cash rent paid.

For Walgreens, this will cost them $456 million in the first year.  My own immediate reaction to this is that these “expenses” aren’t cash, just changes in accruals.  Will it matter?  Well, one way it matters is that it creates bigger book-tax differences:

The phenomenon of non-cash expenses exceeding cash expenses will also create large deferred tax balances. In the United States, companies typically have a composite income tax rate of about 40 percent. This means that Walgreen’s will have a deferred tax receivable that will exceed $1 billion in 10 years. For a going concern, the deferred tax receivable will be permanent as well. These impacts are huge.

If you want more details, and spreadsheets to play around with to estimate cash effects, here is an excel spreadsheet.  Bill provides the following explanation to me in an email:

Rob,

I am always looking for an ear on the lease accounting project. I think it is going in the wrong direction. The Boards are about to reverse their thinking re lessor accounting after months wasted. They received several unsolicited letters criticizing their approach.

They persist on a lessee approach that will distort the asset side of the B/S, the P&L and the cash flow statement. They also persist on capitalizing contingent rents and options where the past event that makes to item legally enforceable has not not occurred (don’t meet the current definition of a liability).

Since I last emailed you I did more research. I have created an example (see attached) of a commercial real estate lease to illustrate the difference between the proposed method and current GAAP. I used the US National Retail Tenants Association to get the terms to insure they are market terms. Before I created this example I had been using footnote information from public company financials to model the impact of converting to the proposed rules. I thought the distortion was large – for instance Walgreen’s (a major US retail company) would report 23% higher lease costs if its footnoted rents were capitalized when the new model is implemented. I reported this information in my CFO magazine white paper but I knew that the calculations understated the effects because I had no information on renewal options or contingent rents.

In my example I assume a 10 year lease with 4 five year renewal options. The real estate is a prime retail location that the lessee is likely to stay in but is not compelled to stay in. Base rent of $30,000 annually increases 10% or $3,000 every 5 years. The lease includes percentage rent increases based on CPI and sales that occur every 5 years. For CPI, the % increase in CPI is applied to the base rent and not compounded. For the sales based contingent rents, 2% of sales over a $3 million threshold is added to rent. I assumed sales increase $500 thousand every 5 years. I assumed CPI increases 0.2% per year with 3% as the base year CPI. The results were surprising. Lease cost in the first year under current GAAP would be 31,500 while it would be 67,234 under the proposed model – an increase of 113%. The imputed interest cost exceeds the cash paid for rent for the first 10 years of the lease so there is negative amortization of the lease obligation. It takes 17 years out of the estimated lease term of 30 years for the non-cash rent to be less that the cash rent (17 is the “turn around” year for the temporary difference). I think this is very hard to understand for users because they traditionally have thought of leases as rental contracts. Additionally the estimated rents and lease term can vary significantly creating volatility in P&L, hence the need for expanded disclosures.

In my example the Lessor/lessee negotiations would go something like this – The lessor proposes the lease terms. The lessee has done its analysis and has determined that if sales increase it will have received cash and profits more than sufficient to cover the variable rent based on sales, in fact gross margins will increase. The lessee also believes that if CPI increases it means general prices will rise (so the lessee can raise prices) and despite the increase in variable rents based on the CPI formula, increases in retail prices will still create enough cash and accounting revenue to pay the increased rent, cover accounting costs and report greater gross profit margins. The bargain is struck – future cash receipts and revenue more than cover future costs and cash needed to pay rent and the lessee is satisfied. Unfortunately this is wishful thinking as the new model’s financial reporting of the lease distorts the economics of the bargain negotiated by the parties. I know this is “old school” thinking but where is the matching of expense with income? The economic distortion will confuse readers.