The Market Threat You Don't Know About

 | Aug 12, 2011 | 9:00 AM EDT  | Comments
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Why on God's green earth am I writing a missive on proposed accounting rule changes when credit default swap spreads throughout the euro zone are being blown to shreds and the equities markets are bending like an old suspension bridge? Very simply, nobody else is discussing the topic, and that is why, when the rule changes are implemented in 2013, they will deliver shock and awe to the masses. Being prepared is instrumental to investing.

The changes that will go in effect, in an attempt to create a global level playing field, go too far and seem devoid of any understanding of the far-reaching financial effects on publicly traded entities or those who desire to raise seed money. So print this article and tape it to your fridge.

Background

While the Financial Accounting Standards Board is being true to the items enshrined on its mission statement, the proposed changes to lease accounting will come at the wrong juncture in our economic recovery path. Some six years into its internal debate on the topic of lease accounting, the FASB has zeroed in on implementing the rule changes starting January 2013 and continuing to 2015.

Under existing GAAP standards that have been in place since 1976, a lease is characterized as either an operating lease or a capital lease. Operating leases are generally not reflected on a company's balance sheet, and therein lies the problem. Critics of the current standard have gripes:

1. It lacks transparency for users of financial statements (true).

2. It reduces the comparability of financial statements between companies (true).

The FASB indeed has planted a ticking time bomb, perhaps using the public outcries of shoddy bank financial statements and possibly inflated earnings during the expansionary years of 2005-2007 to support a sweeping overhaul. From what I have read on the topic, financial statements for retailers or any company that leases something will appear drastically different as the calendar turns to 2013:

* There will be no further distinction between operating and capital leases.

* The new standard will apply to all leased business assets, with few exceptions.

* All leases in existence as of the effective date of the new standard will be subject to the new accounting rules.

* Assets and liabilities will be recorded on a lessee's balance sheet.

* The assets and liabilities will be measured on a basis that 1.) assumes the longest possible lease term, 2.) includes contingent rents, and 3.) is updated when changes in facts or circumstances indicate that there would be a significant change in those assets or liabilities since the previous reporting period.

The Impact

According to estimates I have unearthed, about 70% of the up to $1.3 trillion that would be transferred to U.S. corporate balance sheets under the new guidelines would be real estate leases. Yikes! Make no mistake about it, the impact to earnings and valuation for companies is not drummed up -- it will be very real.

I happen to believe that the market, which is preoccupied with more near-term considerations, ranging from political instability to international instability, is overlooking this information. I suspect, however, that by the middle of 2012, the market will become sensitive to the impact on financial statements, especially if developed economies fail to return to trend growth.

* Substantial internal efforts by the companies themselves will have to be undertaken, such as hiring outside consultants to measure the impact of the rule changes to updating computer software. Little things like this add up, and for a publicly traded company, running lean and mean is the ticket to glory.

* Higher rents will have to be recorded, on the basis of the "most likely term and expected outcome" technique.

* Expanding liabilities on balance sheets can make a company appear weaker, and that could affect valuation and the credit rating.

* Debt covenants in finance agreements may be violated or triggered because of material changes in applicable financial ratios (I am most concerned about this one).

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