Retailers face six-month countdown until lease accounting changes take effect
The retail industry is riding waves in unprecedented stride. By now, the challenges faced by retail organizations are well-documented: Changing consumer demands and the growth of digitization are topics that have dominated the headlines and preoccupied the c-suite as they look toward an increasingly unknown future. In the distance, a new wave of significant financial reporting changes is soon to arrive at full force, in particular for those who have yet to comply.
The imminent arrival of new lease accounting regulations is set to “bring leases to balance sheet,” requiring retail operators to recognize and report almost all leases — with the exception of low-value asset leases and short-term leases lasting less than 12 months — as assets and liabilities once IFRS 16 and ASC 842 come into force in January 2019. The objective of the new standards, which were established by the International Accounting Standards Board and Financial Accounting Standards Board, is to improve transparency, comparability, and financial reporting, but the process requires a significant amount of attention to be paid to ensure the demands of compliance are met without penalty.
Retailers have been relying on lease arrangements as a cost-effective strategy to invest in stores, point-of-sale systems, distribution centers, and transportation equipment, so the impact of the new standards on retail operators does not come without weight. It is estimated that at least 35% of global retail entities will see an increase in debt of over 25% according to a PwC report, with a median increase in debt of almost 100%. By bringing leases to balance sheet, the implementation of new leasing standards may expose billions of dollars in lease liability across the industry.
Creating an articulate and responsive lease accounting model has long been a crucial pain point for retail operators. The new reporting requirements add a new layer of complexity, in particular in the following ways:
• Leases for retail space are often structured with a series of renewal options that provide the retailer with operating flexibility. In a change from previous accounting standards, the exercise of renewal options now triggers a possible reassessment of the lease’s operating versus financing classification, which would also involve a revaluation of the right-of-use asset and related lease liability.
• Retailers increasingly rely on outsourcing arrangements for non-core functions, such as warehousing operations and data center hosting. Some retailers have set up shop within other businesses to operate “store-within-a-store” concepts.
Under the new requirement to record leases as assets, retail operators must now evaluate these arrangements to determine whether they contain a lease contract or constitute an embedded lease. In the latter case, retail operators will need to separate the lease component from the service contract, and record the asset and liabilities for the lease component.
• Retail insiders have become familiar with the financial implications of sale-leaseback transactions and build-to-suit contracts. Under the new lease accounting rules, not only will retailers need to change their back-office processes, but decision-makers will need to adapt their expectations on how these transactions affect financial statements. Retailers with dual reporting obligations under US GAAP and IFRS will face further complexities because accounting for these common arrangements differ from ASC 842 and IFRS 16.
Under the new standards, retail companies will require access to accurate and real-time leasing data to identify the values, payments, and depreciation of leases, and to produce the required disclosure reports. Working out discounted cash flows to calculate lease liabilities and right-of-use assets without specialized software can be extremely difficult to do at scale.
However, the corporate accounting team can diligently manage the challenges and achieve compliance without sifting through spreadsheets of duplicate or missing information by adopting lease management and accounting technology that centralizes data and automates accounting. Lease administration technology can help to identify everything that meets the definition of a lease, determine if contracts meet any exemptions, streamline accruals, payments, or reconciliation, and publish necessary disclosures.
Effective lease management and administration extends beyond the imminent compliance deadline. By establishing a leasing administration ecosystem, companies thinking beyond short-term compliance will find it possible to parlay the requirements of compliance into strategic operational decision-making.
For most retail organizations, the implementation of IFRS 16 and ASC 842 will mark the first instance where they hold centralized and organized leasing data. As they gain a clear view of leasing assets and liabilities, companies can then derive the data-driven insights needed to cut costs and streamline supply chains.
Early adopters are already leveraging a centralized lease database to identify long-forgotten leases, shed liabilities, and consolidate lease terms for more favourable contracts. In a world where retail winners depend on increasingly lean-and-mean operations, comprehensive data and clear decision-making on leased assets could prove key to long-term strategic success. The road to compliance could be long, and is definitely mandatory, but it is undoubtedly worthwhile.
Imran Mia is a lease accounting expert at enterprise software provider Nakisa, which works with world-leading organizations to plan, transition, and comply with new leasing standards and financial regulations.