Prepare For Change: New Lease Accounting Rules to Affect Retail, Restaurant Industries

The Financial Accounting Standards Board (FASB) and its international affiliate, the International Accounting Standards Board (IASB), are currently reviewing proposed new lease accounting rules that, if approved, will significantly affect the retail and restaurant industries.

The upside of the changes is that under the new rules, rent will no longer appear on the income statement. The downside is that it will be replaced by amortization and interest charges. These are typically higher in the first years of a lease and lower in the latter years, so the first-year costs of some long-term leases will show as twice the amount of current rent based on Generally Accepted Accounting Principles (GAAP). In addition, after the changes, the relatively benign footnote that now details future lease obligations will be replaced by asset and liability accounts on the balance sheet. The asset account will recognize the lessee's right to use the leased property, while the liability account will record the obligation to pay rentals.

The new rules will impact the retail and restaurant industries more than others because they will require companies to record on their financials the enormous number of leases for the nation's shops and eateries. The rules will not allow grandfathering of existing leases, will require that lease option periods be considered and recorded for the longest period more likely than not to occur, and will even mandate that contingent rents such as percentage rent be estimated and booked.

Recording these leases will affect traditional financial-statement ratios and metrics such as net operating income (NOI), return on investment (ROI), and EBITDA. For instance, recording all the leases at once - each with a higher initial-year impact on earnings - will lower NOI and ROI in the first years after the change. Interestingly, EBITDA will be higher, because the operating-expense rent will be replaced by interest and amortization. Because new, large asset and liability accounts will cause the balance sheet to balloon, companies may have to restructure current debt covenants with lenders to avoid inadvertent defaults. For example, covenants related to interest-coverage ratios and debt-to-equity ratios will immediately be affected, so some companies may be out of compliance after the change from day one.

In addition to their impact on finances, the new rules will demand substantially more time and energy from companies' accounting and finance, real estate, lease administration, IT, and tax departments. Even after the initial conversion to the rules takes place, there will be ongoing monitoring, estimating, and recordkeeping for each quarterly accounting cycle. Independent auditors will need to spend more time handling the more detailed data required for the many more leases required to be on the books.

It's estimated that the new rules will be released by this summer, with their effective date unlikely to be before 2013. The FASB/IASB has published two drafts of the rules since 2009 and received comments on them from hundreds of different organizations and individuals. These comments range from acceptance to outright rejection and pleas for the status quo. Previous changes to GAAP standards have been delayed and drastically revised before being released, so it is difficult to predict when and in what form the final rules will emerge.

What should retail and restaurant company management do to prepare for the changes? Certainly, chief finance and accounting officers should be working with outside auditors to prepare the systems and collect the data necessary to implement the changes. Doing this early can give companies a better view of the impact on their financial statements, enabling them to estimate the likely negative first-year impact on earnings and deal with it in the investment community. The probable change in financial ratios will be evident and, if necessary, reasoned dialogue with lenders can commence early, rather than at the last moment. The effort will also produce information that can be used to model such issues as lease versus buy, longer versus shorter terms for leases, options, and contingent rents. It's essential to report this change to the board of directors early.

Companies can also choose to use the time until implementation of the new rules to more aggressively pursue restructuring of certain leases. For example, it may be better to deal with underperforming retail and restaurant locations with long-term leases sooner rather than later. For some companies, terminating these leases or modifying their terms may make sense.

Dwayne Shackelford is a principal with Huntley, Mullaney, Spargo & Sullivan, Inc., a financial restructuring firm. He can be reached at dshackelford@hmsinc.net or (916) 705-9669.