Supply Chain

Why a Lease Isn’t Always a Lease

By Chris Steele, President Real Estate Line of Business, TranSystems

In last month’s column, I explained how each real estate decision carries with it implications for a company’s access to markets and labor, and that its operating costs impact the balance sheet, tax and regulatory exposure, and other items important to the company’s success. This month, we will focus on how these transactions — and leases in particular — affect the company’s balance sheet.

Lease Accounting

Leases do not necessarily look the same to an accountant as they do to an operations executive or even the accounts payable clerk who actually processes the payment. Instead, it is the responsibility of the company’s accounting department to determine and report the company’s direct, and/or implied, financial commitments contained within the lease agreement. The Federal Accounting Standards Board (FASB) puts forth guidelines for how this should be computed in the Statement of Financial Accounting Standards No. 13 (FAS 13) and in subsequent adjustments.

Understanding FAS 13

Primarily, FAS 13 sets forth guidance as to whether a lease should be defined as an operating lease or a capital lease or, put another way, whether the lease should be booked as a recurring expense or booked as if it were “owned” by the leaseholder.
Picture a situation where you as the operational manager come back from resolving a difficult logistics problem and report the following to the company CFO: We have been able to find good warehouse space, and — given that this is a location we want to be in for some time — have negotiated a ten-year lease (with an additional ten-year option). Given the great location, we have negotiated the opportunity to buy the facility at a discount at the end of the lease term.

The CFO will likely cringe as this information is reported, because although you may have saved some operating expense and positioned the company well strategically, you have also likely acquired an asset that needs to be reported on the company’s books.

Expense or Formal Commitment

Four key tests in FAS 13 determine whether a lease is simply an expense or a more formal commitment on the lessee’s part. They are:

• Does ownership of the asset/facility transfer to the lessee at any point?

• At the end of the lease, is there an option to purchase the facility at a below-market price?

• Does the lease period account for over three-quarters of the useful life of the facility?

• Does the total net present value of the minimum rent payments account for 90 percent or more of the fair market value of the facility?

In order to keep a facility lease as a simple expense, the lease you negotiate must not fail any of the above four tests. Even so, please note that the government is considering substantive changes to FAS 13 (partially as a response to perceived abuses of the Operating Lease rules). This will result in changes to those four tests for Operating Lease treatment. In fact, it may force the capitalization of all leases to corporate balance sheets. The project is now underway, and a final pronouncement is expected by 2011, if not sooner.

OK, so we have a little bit of a window into accounting treatment, and why the green eyeshade folks give us a hard time sometimes. How about the rest of the financial picture, like whether it makes sense to lease or to buy our real estate, especially given the current financial market? Sounds like a good topic for the holidays (or just after, when we’re all looking at those credit card bills).