By Bill Bosco
(November 1, 2010) Is the economy the biggest threat to earnings of U.S. retailers? I think that a bigger threat may just be a proposed lease accounting rule change.
The Financial Accounting Standards Board (FASB) has issued an Exposure Draft (ED) of proposed new rules for lease accounting that essentially will turn operating leases into capital leases for accounting purposes. (The ED is available for review on fasb.org.)
The degree of unfamiliarity among the nation’s retailers about the proposed rule change is stunning, especially considering the potential devastation it will wreak on earnings. Currently, the accounting rule (Financial Accounting Standard 13) requires only off-balance sheet footnote disclosure of future operating lease obligations. The proposed new rule, however, does much more than merely capitalize leases as the analysts do. It capitalizes estimated renewal and estimated percentage rents, so much more is capitalized than expected.
Many believe that estimated renewals and percentage rents do not meet the definition of a “liability.” The ED requires that the estimates be reviewed and adjusted when there is a material change (this could well mean monthly). Also, the FASB decided that average rent expense is not lease expense but rather amortization of the capitalized asset, and imputed interest on the capitalized liability is the reported P&L cost of the lease. The result is a front-ended lease cost pattern, which many believe doesn’t reflect the economic cost pattern of a lease.
The front-ended pattern causes the increased lease cost to accumulate until the midpoint of the lease term, at which point it turns around so that lease costs are lower in the second half of the lease. Given Wall Street’s “what have you done for me lately” philosophy, it is not good to have better earnings in the future, while you have lower earnings now.
In the chart below, I’ve estimated the impact of the ED’s lease-cost pattern versus current GAAP rent expense for a lineup of the largest U.S. retailers. (I used footnoted future operating lease payments from the retailers’ 10K annual reports.) The results are actually understated compared with the ED’s capitalization model, as estimated renewals and percentage rents are not captured. Looking at Walgreens, for example, if the impact is three times the above, its pretax earnings will drop by 50% in the first year under the proposed rule change.
The first step that every retailer needs to take is to become educated about the proposed rule change and how it can/will impact earnings. As I urged attendees of the National Retail Tenants Association annual conference in Anaheim, Calif., during my September keynote address, start by reading the Leases Project ED, evaluate its implications, and then write a comment letter to FASB. It is not too late to change the direction of the rules, and there are alternative views that have sound basis, but if you do not comment to the FASB, the ED will become reality.
The deadline to submit comment letters is Dec. 15, 2010. For a link to comment letter guidelines, as well as more details about FASB and its potential impact on retailers’ bottom lines, visit chainstoreage.com/webexclusives.aspx .
Bill Bosco is president of Leasing 101, a New York City-based lease consulting company. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. An author and frequent speaker on leasing topics, Bosco has been named to the FASB/IASB Lease Project working group.