New Lease Accounting Standard Causes Concern for Retailers

Even before the FASB issued its new lease accounting standard, ASU 2016-02, Leases (Topic 842), on February 25, 2016, it had long been top of mind for CFOs who were worried about its far-reaching implications. While the standard is designed to bring greater transparency on companies’ lease assets and liabilities, it’s estimated that up to $3 trillion of leasing commitments will have to be added to balance sheets.

The new lease accounting standard, which is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, requires:

Lessees: to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.

Lessors: to classify leases as either sales-type, finance or operating.  A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing.  If the lessor doesn’t convey risks and rewards or control, an operating lease results. A modified retrospective transition approach is required for lessors for sales-type, direct financing, and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.

While the new lease accounting standard will impact industries across the board, it will arguably have the greatest influence on the retail sector, since retailers largely depend on leasing for their operations. Testament to this is the results from our tenth annual Retail Compass Survey of CFOs, which revealed 43 percent of CFOs are concerned about the new lease accounting standards.

The new standard is likely to impact key performance metrics and possibly real estate strategy. Specifically, it will significantly increase both debt and EBITDA for retailers, which should prompt companies to assess the impact on its leverage ratios and borrowing capacity.

According to my colleague Stuart Eisenberg, national leader of the Real Estate and Construction practice, “For many businesses, retailers in particular, the largest asset and liability on their books could become their lease obligations. The challenge will be in explaining that to investors and lenders, so some metrics will have to change.” Stuart continued, “Currently, retailers and other operating businesses have elected to lease rather than buy locations, or even sell and lease back existing locations, to reduce balance sheet assets and liabilities to appease the investment community. This new rule may cause a major shift in management plans, as the balance sheets would reflect large ‘non-income producing’ assets and associated debt or lease liabilities, whether a business chooses to lease or own the space in which it operates.”

As noted in our SEC Flash Report, “These disclosures will be expected to evolve over time as companies begin to better understand how the standard will impact their financial statements.” And it will be interesting to watch how they influence and shape the future of the retail industry. For more information, read our Flash Report.

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