The Accounting Rules, They Are a Changin’ – Part 2

As a follow up to my previous post regarding the upcoming reclassification by FASB of operating leases to capital leases, which you can read here, I’ll outline a general strategy that companies can use to  minimize the reporting impact and unpleasant surprises.  Here’s what I recommend as a checklist of Top Ten Operating Lease to Capital Lease Actions:

1.  Begin Tracking Lease Present Value -  If your lease management software does not already do so, add a few columns showing the remaining obligation of every lease.  Ideally, you’ll show this in both a cash obligation and an amortized straight-line value, with a break out of payments for easy Present Value calculations.

2.  Begin Tracking Market Value - How does your current rental rate compare to market?  In today’s exciting commercial real estate arena, the rate you are paying might be significantly off what the current and competing landlords are charging for comparable space.  When the new rules kick in, you’ll probably need to adjust this number quarterly.  For now, simply make sure you know the current rates for the bulk of your locations and then tweak it every six months so that you can reasonably forecast the delta.  If you have any properties that represent more than 25% of your total rent obligations, start updating them quarterly.

3.  Meet with Your Accountants/Auditors – Discuss the proposed changes, and explore methods to minimize the potential impact.  Identify information that will be needed and establish a routine to gather necessary data and keep updated if you do no already do so.

4.  Prepare a Balance Sheet and P&L forecast under the new regulations - Since final details are not known, to start I’d suggest taking every lease with a term greater than 1 year and listing the present value of the remaining obligation as a long term debt.  Then list the same leases as an asset using a PV of the rent schedule (adjusted for market value if you know if – at face value if not).  Calculate the depreciation and amortizing interest costs using current Capital Lease rules and add to your P&L statement, removing the current rent expense.

5.  Calculate the New Debt/Equity Ratio and EBITDA - Any issues?  Consider any impact that the new numbers may cause with loan covenants or compensation agreements.

6.  Communicate Internally - Send a quick summary of the potential impact and the upcoming changes to the executive, financial, and legal staff within your firm who will be involved or impacted when the changes come through.  Ask them for feedback and for any issues that they foresee and/or want to avoid.

7.  Meet with Your Real Estate Advisors - They will be able to discuss a more detailed strategy based upon your particular property holdings and corporate structure, and can share ideas that other companies are doing to take a proactive approach.

8.  Begin Evaluating All New Leases as Capital Leases - Take whatever lease analysis method that you use now and show the impact of the potential future leases as capital leases as well as operating leases.

9.  Consider Lease, Purchase, and Sale Opportunities - Since the major deterrent to ownership of real estate by corporations has historically been having a depreciating asset and corresponding debt on the balance sheet, you should now also start evaluating purchase opportunities for long term space requirements as current lease terms approach expiration.  Likewise, using Sale/Leasebacks to free up operating capital will likewise have a lesser impact on the balance sheet.  Evaluate all feasible scenarios.

10.  Take Your Banker to Lunch - This would be a good time to discuss the proposed change and how the revised reporting rules will effect all corporations, and yours in particular.  If he/she gives you any assurances, ask for a follow up letter that you can distribute within your organization.  If you don’t get one, write your own.

Develop a strategy now to gain an advantage over your competitors.  Smart companies will take a proactive approach to optimally position themselves when these rules finally take effect.  Because when it comes to surprises on your balance sheet – Less is More.