Capital Ideas: The Leaseback Effect

Accounting treatments of sale-leaseback deals can distort free cash flow, a new report reveals.

Last December, casual-dining chain O’Charley’s Inc. sold six restaurant properties to an unrelated entity, CNL Restaurant Capital LLC, and then leased them back under a 20-year operating-lease agreement. The Nashville-based company recognized a gain of about $17 million on the transaction and, for accounting purposes, considered the transaction a financing event.

Finance executives at the company say they viewed the chain’s sale of unappreciated assets as a way to raise capital, like issuing debt or equity. Since those moves would have been reflected on O’Charley’s cash-flow statement as a financing activity, that’s how the executives recorded the proceeds from the transaction: as cash from financing.

The accounting treatment seems like the logical way to book such a deal. Yet, according to a new study, O’Charley’s is clearly in the minority when it comes to how it records the sale proceeds from sale-leaseback transactions.

The research, conducted by the Financial Analysis Lab at the Georgia Institute of Technology, looked at 37 nonfinancial public companies that entered into operating leases through large sale-leaseback transactions over the last six years. booked Thirty of the companies booked the sale proceeds as cash from investing, while just seven reported the sale proceeds as cash from financing activities.

That’s understandable, since companies that book the deals as cash from investing can include the proceeds in their free-cash-flow calculations. Companies that account for the deals as cash from financing can’t do that.

The problem is that the choice of investing-cash treatment for sale-leasebacks can distort the reporting of free cash flow. For companies that used the cash-from-investing treatment, study co-author and lab director Charles Mulford subtracted the sale proceeds from free cash flow. The adjustment caused significant decreases; for example, companies such as AMC Entertainment, Carmax Inc., and CVS Corp. dropped from a positive to a negative free cash flow.

Mulford stressed that none of the 30 companies violated generally accepted accounting principles and that there’s no evidence of ulterior management motives in the choice of accounting treatment. In fact, auditors probably don’t focus on the free-cash-flow effect either, says Ben Neuhausen of audit firm BDO Seidman. “Free cash flow is not a defined accounting term” under GAAP, he says. Rather, it’s a performance measure.

What Mulford finds more troubling than the distortions, however, is that two companies in the same industry, entering into identical transactions, could report the sales proceeds in completely different ways. That would end any true apples-to-apples comparison of free cash flow among companies. “If a company records the proceeds as cash from investing, analysts and investors potentially can be misled,” Mulford told

The consequences are serious, since free cash flow, which measures a company’s ability to generate cash, has always been a primary yardstick used by investors and analysts to value companies. What’s more, sale-leaseback transactions are a common off-balance-sheet transaction used by many companies to rid their balance sheets of assets while retaining their full use.


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