Retailers Must Make Major Adjustments for New Lease Accounting

Accounting rules on leases are sure to change in the near future. International and U.S. standard-setters have both introduced new proposed standards are likely to be finished in 2011 and take effect in 2013.

The New York Times quotes the SEC as stating that $1.3 trillion in leases will be added to public company balance sheets.

The standards will add significant liabilities to balance sheets and may jack up expenses as well.

All leases will be affected, including those currently classified as operating leases and fully expensed as there is no grandfathering clause when the rule takes effect.

The standards require companies to record as a liability the cost of rent over the remaining term of the lease and record as an asset their right to use the space.

This could have diverse impacts, including weakening companies in the eyes of investors and activating debt covenants with lenders.

It could also affect credit ratings. Ratings agencies say they already take into consideration rent obligations by using a multiplier on operating lease payments to arrive at an estimate of capital lease obligations. However the new standard requires significant additional disclosures that could provide readers of financial statements with additional information about corporate leases, possibly not known before, and possibly damaging to credit capacity.

The thrust of the change is part of the trend to limit off-balance-sheet activity. The standard-setters received almost 300 comment letters commenting on the proposal.

Certain companies with high debt loads may be adversely affected by adding new debt to their balance sheets. Also impacted heavily will be large retailers that may have thousands of premises leases, as well as commercial banks with multiple branches. Tracking leases and analyzing them to convert them to on-balance-sheet status may be problematic.

The standards may have the impact of persuading companies to purchase rather than lease real estate, to avoid either the ongoing administrative burden of analyzing and classifying and accounting for capitalized leases, or to have more conventional and possibly lower-cost debt on their balance sheets.

Companies may also opt for shorter leases as they will have less debt on their balance sheets that if they have longer terms.

Renewal options may become less popular. The new rules require that if a company expects to execute a renewal option, they must account for the lease as if it included the option, in many cases doubling or tripling the face/undiscounted amount of the lease liabilities and adding debt to balance sheets.

Contingent rents, based on a percentage of sales will trigger additional debt as well, based on estimated sales over a lease term. Most retailers in shopping malls fall under these types of structures. Retailers forced now to estimate sales way into the future, and to reassess these estimates at every (quarterly).

On the other side of the lease arrangements, landlords will also change their accounting. Landlords would record as a liability their obligation to provide space and record as an asset the rents they expect to receive. Under the new standard the rents will be recorded partly as interest income and partly as a reduction in the obligation to provide space.