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Fixed, long-term leases can backfire for many companies.

Fixed, long-term leases can backfire for many companies

While negotiating long-term commercial leases with low, fixed annual increases is acknowledged to be sound business practice, long-term deals can backfire for many companies, particularly those in a growth phase, that don't carefully consider the larger ramifications on Generally Accepted Accounting Principles (GAAP) earnings.

According to an analysis by The Lexington Group, Ltd., a New York City-based financial services firm, accounting for expense from a multi-year lease can potentially "penalize" a company's reported GAAP earnings enough to weaken its borrowing power.

As John Delucca, president and chief operating officer of The Lexington Group, explains, "Long-term, low-increase leases may appear conceptually to be best, particularly for a business in a growth or start-up phase. But because they are expensed on an average basis over the course of the lease, they can impact earnings."

A fairly obscure but significant provision of accounting regulation FASB #13, which governs the treatment of operating leases, states that if scheduled rent increases are known, rent expense must be recognized on a straight-line basis over the lease term.

Matt Kahn, a managing director with The Lexington Group, which advises clients in such areas as lease structuring and managing for cash flow, explains by example that a 10-year lease with $10,000 rent in the first year and fixed $100, or 1 percent, annual increases, would generally be considered a wise business arrangement. Following GAAP, the annual rent expense recorded in the financial statements is $10,450, although the cash expense is only $10,000 in the first year of the lease and increases by $100 in each succeeding year.

The $450 difference in the first year represents a deferred liability on the balance sheet. In the first year, the GAAP expense will exceed the cash paid by $450. While the deferred liability will reverse itself for each lease in later years, for a company such as an aggressive retailer opening many more stores with similar long-term leases, the new leases combined are contributing to an overall increase in deferred liabilities and GAAP lease expense.

In a second example, the tenant negotiates a 10-year lease but, as an inducement, pays no rent the first year. The tenant would pay rent of $10,000 in the second year and $100 more in each succeeding year.

In year one, no cash is paid for rent, but the company records annual rent expense of $9,360, using the straightline principle.

These simple examples illustrate the effects this method of accounting can have on GAAP earnings.

"Particularly when a company is in a growth stage, cash flow is critical," Kahn explained. "Negotiating fixed, low annual rental increases represents one way companies can manage wisely for cash flow because that avoids the economic uncertainities of rent escalations tied to an unknown measure such as CPI.

"But the negative impact on GAAP earnings must not be ignored in leasing arrangements. While banks and other potential lenders/investors consider cash flow, a critical component for them is GAAP financials. The ventures that demonstrate the most attractive GAAP financial statements will almost always gain the favor of lenders when they must decide which projects to approve for funding," he said.
COPYRIGHT 1991 Hagedorn Publication
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Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:Real Estate Weekly
Date:Jun 5, 1991
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