Retail Detail: Proposed New Lease Accounting Rule Changes Will Have A Significant Impact On The Retail Industry

DON'T let the words "lease" and "accounting" in the title fool you into thinking that the rule changes that are coming will not affect you since your work in the retail industry has nothing or very little to do with either leasing or accounting. While the changes that are coming will have significant impacts on all industries, retailers will be particularly hard hit as a result of their reliance on leased facilities. The rule changes that we have outlined below may adversely affect the financial condition and value of your company….so keep reading!

Issues with the Current Lease Accounting Standard

In the United States, generally accepting accounting principles (GAAP) relating to lease accounting have seen little change since 1976 when the U.S. Financial Accounting Standards Board (FASB) implemented FASB Statement 13. Under the current standard, leases are characterized as either an operating lease or a capital lease. Operating leases are not generally reflected on a company's balance sheet. Critics of the current standard contend that operating leases in fact give rise to an asset and a liability which should be disclosed on a company's balance sheet, and that by failing to do so, the current standard (i) provides a lack of transparency for users of financial statements that require a complete understanding of a company's leasing activities, and (ii) reduces the comparability of financial statements between companies that account for their leases differently. These "off-balance sheet" operating lease obligations translate to significant fixed and contingent liabilities for companies, particularly retailers with hundreds or thousands of retail locations, which some have estimated to be in the $1 to $2 TRILLION range across all industries.

Timing of Proposed New Rules

In the aftermath of the numerous corporate scandals and bankruptcies in the early part of the last decade and the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission issued a report in 2005 relating to off-balance sheet arrangements which requested FASB to re-examine its lease accounting rules in order to provide complete transparency in financial reporting. In response, FASB commenced a joint project with its international counterpart, the International Accounting Standards Board (IASB) to merge their existing rules into a new lease accounting model which resulted in a general outline of a new lease accounting model that was set forth in a Discussion Paper issued in March, 2009, and an Exposure Draft that was just issued in August, 2010. While no fixed date has been determined for the issuance of the final standard, it is generally expected that the final standard will be issued mid-2011 and will become effective as early as 2012.

Proposed Changes in the New Lease Accounting Model for Lessees

While the Exposure Draft addresses new accounting rules for both lessors and lessees, the primary focus below will be on the basic changes affecting lessees. The lease accounting model contemplated by the new standard is a "right of use" model that assumes that each lease creates an asset (the lessee's right to use the leased asset) and a liability (the future rental payment obligations) which should be reflected on a lessee's balance sheet to fairly represent the lease transaction and the lessee's related financial obligations. The specifics of the new proposal provide for the following basic principles:

• there will be no further distinction between operating and capital leases
• the new standard will apply to all leased business assets with few exceptions and not just real estate leases
• there will be no so-called "grandfathered" leases so that all leases in existence as of the effective date of the new standard will be subject to the new accounting rules
• a lessee's balance sheet will reflect an asset representing the company's right to use the leased asset, and a liability representing the company's obligation to make rental payments
• the assets and liabilities will be measured on a basis that (i) assumes the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or to terminate, (ii) uses an expected outcome technique to reflect the lease payments, including contingent rents (such as percentage rent), residual payments (such as guaranteed residual value payments) or expected payments under term option penalties, and (iii) is updated when changes in facts or circumstances indicate that there would be a significant change in those assets or liabilities since the previous reporting period.

Impacts of the New Proposal on Retailers

While some of the complexities in measurement and reporting are beyond the scope of this article, the new lease accounting standard will have a number of far reaching impacts on retailers, particularly those companies that have a substantial number of operating leases. Some of the anticipated impacts that will have immediate effects on retailers include:

• substantial internal efforts, process adjustments and expense will need to be put in place and expended, respectively, in order to learn and implement the new reporting and measurement requirements imposed by the new standard
• higher rents will have to be recorded based on the most likely term and expected outcome technique described above which, based on the impact to financial statements, will require extensive internal analysis and estimates never before required, all of which will result in the addition of significant liability to balance sheets
• expanding liabilities on balance sheets can make a company appear weaker which could affect the valuation of a company from an investor's perspective and the credit rating of a company from a rating agency's perspective
• debt covenants in finance agreements may be violated or triggered due to material changes in applicable financial ratios, and heavily leveraged retailers could become technically insolvent or worse
• retailers may seek to alter their leasing strategy to (i) own assets instead of leasing where appropriate, or (ii) reduce lease and extension option terms to create the desired effect on its financial statements which, in either case, could have adverse repercussions in an already battered commercial real estate market for property owners and investors that are looking to increase their property's occupancy levels.

 Actions Retailers Should Take Now

There is still plenty of time before the new standard becomes effective. However, since the new standard will apply to virtually all business assets and all leases in effect as of the effective date, it would be prudent to start to plan and budget for the affirmative changes to come. As internal changes typically take time and money to implement, particularly when they span different company departments, we would suggest that retailers start by taking the following actions:

• EVALUATE the Exposure Draft and the new lease accounting rules, monitor the comments and review the final standard when issued in 2011
• MEASURE the likely reporting effect across its leasing platform and the potential impact on its balance sheet
• REVIEW the effect of new reporting requirements on existing legal documentation related to its debt obligations and potential adverse effects on the company's valuation and credit rating and consider whether any affirmative action may be required to be taken with its lenders, investors or credit rating agencies in advance of the effective date of the new standard
• BUDGET for and PLAN to implement the internal review, technology and process changes required by the new rules, including (i) educating the appropriate internal groups responsible for assessment, measurement and reporting, and (ii) determining who will make the difficult judgment calls regarding certain decisions such as most likely term, estimates of gross sales for percentage rent purposes, etc.
• RE-ASSESS its leasing program and requirements to take the appropriate strategic action (e.g., lease v. own, shorter terms, fewer options, etc.) to minimize the impact of the new standard while still satisfying its long term business plan and objectives

In short, the proposed rule changes related to the new lease accounting model will have a significant effect on retail industry companies. While the effective date of the new standard is not immediate, it will take some time for your organization to understand the implications of the rule changes and to prepare internally for the new measurement and reporting obligations.

Please feel free to call any of the individuals on our retail industry team listed below for further guidance regarding compliance with these new rules.

Gregg Dorman: (312) 460-5290 or gdorman@seyfarth.com

Andrew Shure: (617) 946-4878 or ashure@seyfarth.com

Kwame Benjamin: (404) 885-6712 or kbenjamin@seyfarth.com

If you would like a copy of the Exposure Draft, please click here or contact  seyfarthshaw@seyfarth.com to request a copy.