The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) (collectively “the Boards”) have issued 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 has decided on 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.
You should also download our latest whitepaper Lease Accounting Business Considerations to help you better understand how you and your firms can prepare for these upcoming lease accounting changes.