The Effects of Lease Capitalization on Various Financial Measures: An Analysis of the Retail Industry

Abstract

The FASB, in conjunction with the International Accounting Standards Board, is currently in the planning stages of a project that would revise SFAS 13, Accounting for Leases. What is proposed is that leases that are presently accounted for as operating leases, that is, those leases that do not meet the current requirements for on-balance-sheet treatment, would be accounted for as capital leases and brought onto the financial statements. For companies that use a significant amount of operating leases to finance operations, the financial statement impact could be far-reaching, including material effects on various measures of profitability, financial leverage, debt coverage and cash flow.

In this research report, we look at the retail industry, an industry that uses operating leases extensively, to evaluate how certain key measures of financial performance and position might be affected by the capitalization of operating leases. Among the findings are an increase in EBITDA, though reductions in income from continuing operations and earnings per share. Financial leverage is increased and debt coverage measures are reduced. Measures of profitability, such as return on assets and return on equity are reduced. Finally, we find an increase in operating cash flow and free cash flow.