How Proposed Lease Accounting Changes Will Affect Retailers
The Financial Accounting Standards Board (“FASB”) and the International Accounting
Standards Board (“IASB”) (collectively “the Boards”) are in the process of completing a major Joint Accounting
Project which will dramatically change the way that lessees account for their portfolio of leases. The objective of
the Boards’ Joint Project was convergence on lease accounting, namely, an international standard for lease
accounting applicable to all business entities. And the Boards have achieved the major guiding principle of the
Joint Project – virtually all lease obligations (except narrowly defined short-term leases) must be recognized on
the balance sheet of the lessee using a Right of Use Asset and Lease Liability model.The initial measurement of the
Lease Liability and the Right of Use Asset will be based upon the discounted present value of the defined lease
payment stream. For most retail companies, this will result in a higher Lease Liability amount as compared with some
other industries because retailers have a higher concentration of property leases with generally higher lease
payments and the lease terms that are generally longer. Given that fact, most retail companies should be
particularly concerned about adding additional debt to the balance sheet in the form of a Lease Liability.The
complexity of the provisions contained in the lease agreement should also be taken into consideration as one
considers the impact of the change in lease accounting. Option periods and purchase options, among other provisions,
will be subject to greater scrutiny to determine whether the lessee is reasonably certain to exercise these
provisions. If so, the payments attributable to these provisions may have to be included in the payment stream used
in the calculation of the initial measurement of the Lease Liability and the Right of Use Asset. Variable lease
payments will also be subject to greater scrutiny to determine whether they should be included in the measurement of
the Lease Liability.
There has been disagreement on some other aspects of the Joint Project that will make
implementation particularly difficult, especially for those business entities that must comply with both US GAAP and
IFRS. Most importantly, the Boards have agreed to disagree on the pattern of expense recognition in the income
statement. The IASB is proposing only one accounting model for all leases resulting in accelerated expense
recognition with the expense being recognized in two line items – interest expense and amortization expense. The
FASB, however, will retain the distinction of a Type A and a Type B lease that was originally proposed by the Boards
in 2013. The FASB approach would use principles similar to what is currently being used for operating and financing
leases to distinguish between Type A and Type B leases. The FASB model would result in most leases having expense
being recognized on a straight- line basis with the straight line expense being classified as lease
expense.
For many retailers, the effort to adopt the new lease accounting requirements for store locations
currently under operating leases will be a major undertaking and will add significant new indebtedness to the
balance sheet. All retailers that utilize leasing as a financing tool will also see a major deterioration in their
debt to equity and debt service coverage ratios. To the extent that retailers have debt covenants that will be
negatively impacted, it will be important to identify these issues early on. Then discussions should be initiated
with banking relationships so that the banks can understand that, while the accounting has changed, the basic
economics driving the business has not changed.
Now is the time to assess the financial planning and
operational aspects of the proposed accounting change. Will leasing strategy have to change? Are there operational
efficiencies that can be achieved as part of the adoption of the new accounting model? What technology enhancements
will have to be made in order to meet the challenges of the new accounting model? The implementation date of the new
standard is yet to be determined but advance planning and early preparation are critical to accomplish as smooth a
transition as possible.
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