Lease Accounting: Falling Rents Will Boost EBITDA

Mandates will make hefty amounts of rent expenses disappear as corporations account for operating leases in a new way, a study finds.

While forthcoming accounting mandates will require many companies to report leasing expenses on their balance sheets, compliance with the rules will boost the EBITDA of companies with operating leases substantially, according to new research.

Last year the Financial Accounting Standards Board and the International Accounting Standards Board decided to amend FAS 13, a 1976 rule that distinguished between capital-lease obligations, which appear on balance sheets, and operating leases, which don’t. The proposed changes would hoist the reporting of operating leases, which make up the great majority of such obligations, from the financial footnotes to the balance sheet.

Executives working for retailers, airlines, and other companies that tend to hold large operating leases have been fearful of the impact of the rule change. Expected to occur sometime in 2009, the amendments have spawned anxieties about possible negative effects on earnings as leases become onerous liabilities. But a new study conducted by the Georgia Tech Financial Analysis Lab shows that the changes will spur a significant boost to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), one of the most widely used gauges of corporate profit.

Looking at the performance of 25 companies during 2006, the study found that if operating leases were handled as capital leases—as the accounting changes will require—
the reported EBITDA of those firms would rise by an average of 17.2 percent. “Given how EBITDA is calculated, any company with rent expense from an operating lease is going to see an increase in EBITDA,” Charles Mulford, an accounting professor and the study’s lead author, told CFO.com.

When operating leases are capitalized, rent expenses disappear and are replaced with interest and amortization expenses, which do not reduce EBITDA. The increase in EBITDA after lease capitalization is greater than EBITDA under operating lease treatment by the amount of the rent expense, the report explains.

Since EBITDA measures a company’s ability to service debt, such an increase could provide more financial flexibility within financial covenants without a firm’s making actual improvements in its performance, according to the Financial Analysis Lab.

Mulford contends that the EBITDA boost could affect retail and technology firms the most because they tend to have the largest holdings of operating leases. The company with the biggest EBITDA increase among those studied was 24/7 Real Media, which would report a rise of 87.06 percent in the metric if its leases were reclassified. Gilman and Ciocia Inc. followed with a rise of 76.44 percent. Also notable was Sears, which would notch an EBITDA increase of 21.67 percent.

Since EBITDA is used by firms to measure performance in financial covenants and incentive compensation agreements, the rise could create increases in incentive compensation based on those performance metrics. The study noted two companies, 24/7 Real Media Inc., and Gilman and Ciocia, Inc., where the compensation for executive officers is directly tied to EBITDA benchmarks.

Although EBITDA is widely used, Mulford suggests that it since it’s not regulated under U.S. generally accepted accounting principles, standard-setters will not focus on the impact that lease accounting changes have on the metric. As the study argues, however, the impact on companies will be real. “Financial managers need to be aware that this is coming,” Mulford says. “They need to start working the potential effects of this into their financial contracts that use EBITDA.” In the meantime, Mulford recommends, corporate finance executives and accountants should consider including rent expense in their EBITDA calculations to accommodate the potential change.

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