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Lease Accounting: The Numbers

In my last post: “Lease Accounting: Type “A” or “B” Lease” I wrote about the open comment period and some of the comments that had been made concerning the proposed changes to Lease Accounting, which, when taken into consideration by the Finaicial and International Accounting Standards Boards, should help bring the proposed accounting changes into fruition.  An article written in the July 2013 issue of Acocunting Today by J. Edward Katz, an associate professor at Penn State University, titled “A lease accounting case study” might help to bring some clarity to the subject.  Again, as I stated in my last post, “this might be venturing a little “into-the-weeds” for some”; however, as Mr. Katz so plainly lays out in his article, the proposed changes “would eliminate the fiction of Operating Leases, requiring business entities to recognize the lease obligations and the leased resources on their Balance Sheets, along with the concomitant changes in the Income and Cash Flow Statements”, and, as I added in my last post, “for any businessperson that deals with finances or is interested in knowing how debt service is actually covered by cash flow, lease accounting should be an important issue”.

In his article, Mr. Katz presented a case study in the drug retailer and pharmacy chain CVS Caremark, where he states, “under the present accounting standards, CVS can legally hide billions of dollars of liabilities and thereby vastly understate its financial leverage and risk”, a statement that gets to the heart of the issue necessitating the proposed changes in lease accounting.  My readers should keep in mind, both the current and proposed methods end at the same or almost the same place, the obligation paid off and the acquired asset written off or down to a lower value; however, as Mr. Katz establishes in his case study, the year-to-year effects of the two methods of accounting for the leases paint a significantly different picture.

Frankly, as one might presume, and as Mr. Katz establishes in his case study, the changes in lease acocunting primarily affect a company’s Balance Sheet.  The changes in CVS Caremark’s 2012 Financial Statements from capitalizing the assets and recognizing the debt from the leases acquired/held are:

  • an estimated increase of “$11.7 Billion to Property, Plant and Equipment”;
  • an estimated increase of “$2.1 Billion in Current Liabilities” (an increase of “16 percent” over the reported current debt in the CVS statements);
  • an estimated increase of “$17.3 Billion in Long-Term Liabilities” (an increase of “121 percent” over the reported long-term debt in the CVS statements); and
  • an estimated reduction of “$7.8 Billion in Stockholders Equity”, or a decline of “21 percent” from the reported measure.

In my opinion, and I hope my readers will agree, these are some significant numbers.  Frankly, it must be kept in mind, the numbers above are only estimates, which Mr. Katz facilitated by: “*finding the lease cash payments (required by FASB13); *choosing an appropriate rate of interest; *computing the leased assets and obligations as the present value of the future cash payments; *estimating the life and current age of the assets, calculating depreciation expense and accumulated depreciation; and *estimating Interest Expense and the changes in Income and Deferred Income Taxes”.  Once again, these conclusions are based on estimates that could be affected significantly by the estimated interest/discount rates, asset lives, etc.; however, in my opinion, any adjustment made to increases of $11.7 Billion to Property, Plant and Equipment or $17.3 Billion in Long-Term Liabilities will not wipe out these increases completely.

As Mr. Katz states, the “Cash Flow Statement will generally improve after one moves from Operating to Capital Leases, because the Operating Lease method treats lease payments as operating cash flows, while the Capital Lease method breaks payments into interest cash flows and payments to reduce the lease obligation”.  With the Operating Lease method, the whole lease/rental payment is recognized in Operating Cash Flow as opposed to the Capital Lease presentation which recognizes only Interest Expense in Operating Cash Flow.

As Mr. Katz concluded, the alterations to the Balance Sheet “impact widely used financial ratios, especially the financial leverage ratios”.  For example, debt-to-equity based on the 2012 reported numbers in the CVS statements came out as “0.74”; however, “employing the more economically realistic numbers, the debt-to-equity ratio becomes 1.60” … quite a difference.

Once again, the numbers are only as accurate as the estimates used to arrrive at them, but a change of a percent or so in the interest/discount rates or a year/couple of years in the life/lives of the assets shouldn’t make enough of a difference to effectively wipe out such significant changes as Mr. Katz arrived at, and as he states, “it would be better if business enterprises reported these lease effects correctly and if auditors attested to them” substantiating the “economic truth which needs to be reported to the investment community, rather than be covered up”.