Lease Accounting Changes

The FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) recently announced a joint project to rewrite the lease accounting standard. The FASB and IASB have tentatively concluded that virtually all leases should be reported on the balance sheet. But most leases are currently considered “off balance sheet” financing. Kelvin Smith, executive VP of Wilton, Conn.-based Financial Computer Systems, Inc., spoke with Chain Store Age associate editor/Web editor Samantha Murphy about how the new rules might impact retailers.

Chain Store Age: How will the new lease accounting standard affect retailers and their store planning operations?

Kelvin Smith: Many store leases set by retailers are for 20 years or more, especially including renewal options. But they are often structured as operating leases. If these have to be treated as capital leases, the impact on the balance sheet could be substantial. Georgia Tech recently released a study quantifying the potential impact on representative retail companies. They estimated a median 5.3% decline in reported earnings for fiscal year 2006. The impact on the balance sheet was considerably greater: 14.6% increase in assets, 26.4% increase in liabilities. This would be a significant hit to financial ratios. These changes may mean that growth requires more capital to meet loan covenants and investor expectations. For some companies, the effect could be several times the median, depending on how they do their leasing.

CSA: How will things change going forward?

Smith: It seems unlikely that existing operating leases will be grandfathered with no change. This wouldn’t meet the goal of getting the commitments on the balance sheet and improving comparability between companies. But we don’t know whether leases will be recalculated from inception or if they will be treated as if they were new on the changeover date. Whenever the changeover happens though, the value of leases will be put on the balance sheet. Over time, some may find they’ve entered into deals that will make less sense in the new regime. I think we can expect to see a fair amount of renegotiation of leases during the transition period.

CSA: What do retailers need to do to meet these regulations?

Smith: The FASB plans to release an exposure draft later this year with a final standard in 2009. It would probably take effect at the start of 2011. However, companies may want to start planning now. They can look at what their exposure is, based on the decisions that have been made so far and considering what adjustments to their financial structure they may need to plan for. Those preparing to acquire new real estate should be particularly concerned that they don’t base acquisition decisions on rules that are about to change.

CSA: How will this benefit or harm retailers going forward?

Smith: Retailers in strong financial positions that can consider purchasing their stores may find that the lease-vs.-buy comparison tilts more toward buying real estate. Weak retailers could find their reported earnings and financial ratios under pressure. Right now, there is a great deal of variation in reporting; some retailers show a large number of capital leases or owned stores, while others have none. The new standard will likely provide more comparability. Whether that’s a good or bad thing may depend on which side of the fence you’re on.

CSA: What technology solutions will retailers need to deploy or leverage to support these changes?

Smith: Capitalizing a lease is much more complex than recognizing rent on an operating lease. Companies that currently use an Excel spreadsheet for their operating leases would need to completely rewrite their models. They are likely to find that dedicated lease accounting software gives much more reliable results, particularly if their lease portfolio numbers in the hundreds or thousands.

However, a vendor can provide not only software that complies with the standard (current and future), but implementation guidance based on the experience of its full range of clients.

Retailers are just starting to pay attention to these changes, but once the exposure draft comes out later this year, more companies will look to vendors for ways to respond.

Visit our Web site, www.ez13.com, for more information on lease accounting and the impending changes.