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Lease accounting changes will impact retail and restaurant industries

By Dwayne Shackelford, dshackelford@hmsinc.net

Proposed new lease accounting rule changes will have a significant impact on many retail and restaurant companies. The good news is that rent will no longer appear on the income statement; the bad news is that it will be replaced by amortization and interest charges, which will generally be larger in the first years of a lease and lower in the latter years.

Some long-term leases under the proposed new standards will show first-year lease costs of twice the amount of current rent based on Generally Accepted Accounting Principles (GAAP). Also, the relatively benign footnote that now details future lease obligations will be replaced by new asset and liability accounts on the balance sheet. The asset will recognize the lessee’s right of use for the leased property and the liability will record the obligation to pay rentals. The proposed new standards are in review by the Financial Accounting Standards Board (FASB) and its international affiliate, the International Accounting Standards Board (IASB), and estimates are that the final rules will be released by early summer 2011 with the effective date still not determined, but not likely to be before 2013.

Why is this going to impact the retail and restaurant industries more than most? Simply because the vast number of leases for those impressive looking big boxes and medium to small spaces housing the nation’s retailers and restaurants will now have to be recorded on the financials. All of those leases are going to have to be converted to asset and liability accounts -- the current rules draft does not allow for any grandfathering of existing leases. The new standards will require that lease option periods be considered and recorded for the longest period more likely than not to occur. Even contingent rents such as percentage rent will have to be estimated and booked.

The recording of these leases will impact traditional financial statement ratios and metrics, such as net operating income (NOI), return on investment (ROI) and EBITDA. For example, NOI and ROI will be lower in the first years after the change because all of the leases are being recorded at once, each with a higher initial year impact on earnings. Interestingly, EBITDA will be higher because the operating expense rent, is being replaced by interest and amortization. Additionally, because the balance sheet will have ballooned as a result of new, large asset and liability accounts, current debt covenants may have to be restructured with lenders to avoid inadvertent defaults. For example, covenants related to interest coverage ratios and debt to equity ratios will be immediately impacted -- and some companies may be out of compliance from day one of the change.

Furthermore to the all important financial impacts, there will be significantly more time and energy required by the lessee’s accounting and finance, real estate, lease administration, IT, and tax departments. After the initial conversion to the new standards has taken place, there will be ongoing monitoring, estimating and recordkeeping for each quarterly accounting cycle. Independent auditors will have to spend more time working with the much more detailed data required for each of the many more leases recorded on the books.

A discussion draft of these proposed lease accounting changes was first published by the FASB/IASB in March 2009. After outreach sessions, review and comments, another exposure draft was issued for comments in August 2010. The comment period ended in December 2010 and approximately 800 formal written comments have been lodged with the FASB/IASB. The comments come from all types of U.S. and foreign companies, accounting groups and firms, civic organizations, educators and myriad other interested parties. The comments range from acceptance of the proposed change with a few changes to outright rejection and a plea for the status quo. The majority of the comments (or should they be called complaints?), center around the following issues:

  • Financial statement clarity.  Many believe the changes will result in less clarity in the financial statements than with current GAAP treatment of leases.
  • Option periods. Others question the justification for recording option periods and believe that the requirement will distort financial results. Options will front load expenses and increase volatility of the financials when recorded options are reversed when facts and decisions change.
  • Contingent rents. The need to record such things as percentage rent based upon estimates of future sales for the location of the lease is felt to be unwarranted and overly complicated.
  • Loan covenants and contractual agreements.  Numerous parties expressed concern about loan covenants and other contractual agreements that rely of current GAAP rules.
  • Costs of implementation. The need to commit significant entity resources to implement the changes and then administer them with new updates at each reporting period was expected to be a major burden to many.
  • Timing of change. The Boards’ estimate of a second quarter 2011 finalization date was characterized as too ambitious for such a complicated, controversial and far-reaching change.

Prior significant and controversial changes to GAAP standards have experienced delays and significant changes prior to being released. So, while the new lease accounting rules are supposedly nearing release date, it is difficult to predict when and in what detailed form the final standards will emerge.

What should retail and restaurant company management do to prepare for this change? Certainly the chief finance and accounting officers should be planning with the company’s outside auditors to set up the systems and gather the data that will be needed to implement the change. An early push to set this up can lead to better visibility of the magnitude of the impact on the company’s financial statements. The likely first-year negative impact on earnings can be estimated and begun to be dealt with in the investment community. The likely change in financial ratios will be evident and, if necessary, reasoned dialogue with lenders can commence early, rather than at the last moment. This effort will also provide the information that can be used to model such issues as lease versus buy, longer term vs. shorter terms for leases, options and contingent rents. Some companies may elect to use the time until the changes are implemented to more aggressively pursue restructuring of certain leases. For example, underperforming retail and restaurant locations with long-term leases may be better dealt with sooner than later. Termination of these leases or modification of terms may make sense for some companies and early reporting of this impending change to the company’s board of directors is essential.

Dwayne Shackelford is a principal with Huntley, Mullaney, Spargo & Sullivan, Inc., a financial restructuring firm. He can be reached at dshackelford@hmsinc.net or (916) 705-9669.