Brick-and-mortar stores remain a vital component of multichannel sales strategies, despite the steady march of e-commerce. And for many retailers, leasing that real estate (rather than buying it outright) has been the most economically expedient option.
In 2021, nonpublic companies that report according to U.S. Generally Accepted Accounting Principles (GAAP) will be required to recognize most of those leases on their balance sheets — including operating leases that retailers and others have historically maintained off balance sheet. Complying with the new lease accounting standard likely will require significant changes, therefore, retailers that start now can manage their resources more effectively and start stakeholder communications about the anticipated changes.
The lease accounting standards probably will require changes to the processes and IT systems companies use to track and account for leases. Depending on the number and complexity of leases in your portfolio, you might need to hire additional accounting staff, software experts or other consultants versed in the new rules.
Starting the implementation process now brings the added benefits of being able to communicate early with investors, lenders, and other stakeholders about the changes they can expect to see in your company’s financial statements. In particular, retailers with debt covenants should consider how debt-to-equity and other debt-based ratios could be affected when operating lease liabilities (and their corresponding assets) start hitting their balance sheets at the end of 2020.
On the bright side, retailers who begin early should have additional time to take a more strategic approach to compliance. For example, retailers with the financial capability might use the additional time to identify retail space (or other leased assets) to purchase, thereby avoiding the complexity of implementing these new rules. They might also use the additional time to renegotiate debt agreements to address any identified covenant concerns.
How to Get Started
How do you eat an elephant? One bite at a time. The same philosophy applies to digesting a new accounting standard. The following are some steps retailers should consider as they work toward compliance.
- Be aware. The first step of adjusting to a change is to identify if the new guidance will impact your organization. For retail companies that lease real estate or other significant assets, and reports according to GAAP, the requirement to account for nearly all leases on the financial statements most likely will require substantial changes to how they track, administer, and account for leases.
- Inventory your leases – and their terms. The next step is determining what inside your organization is affected. In addition to real estate, leased assets might include point of sale (POS) systems, computers, copiers, or automobiles. Gather copies of all the lease agreements; then start digging into the terms. How long are the lease terms? (If leases have terms of 12 months or less, you may be able to make an election that exempts those leases from the new guidance.) What costs are included in the lease payments? Nonlease components, such as utilities and maintenance costs, must now be tracked and accounted for separately from lease expenses. Retailers that sell their office space and then lease that space from the new owners (“sale-and-leaseback” transactions) are also required to follow the new rules.
- Begin with the end in mind. The new standard introduces quite a few new and expanded disclosures, many of which require new estimates. Make sure you understand these new disclosures and perform a gap analysis to determine what: 1) information you will need to start tracking and 2) types of adjustments to systems and processes will be required to generate the data. For example, contingent fees that are based on a percentage of sales must be estimated over the entire term of the lease. Consider whether you are able to make those estimates, or whether you need to renegotiate your lease terms to make those estimates more manageable.
- Watch your debt covenants. Once you have a general sense of how the new lease standards will affect your financial statements, run your own calculations to understand the impact to debt covenants. Then, start discussing with your lenders how your ratios might change. If you will need to renegotiate debt covenants, be sure you allow several months for that process. Most important: Don’t wait for your underwriters to flag the problem themselves.
- Think big. Getting started early allows you to consider strategic changes that might make implementation easier while achieving your operational objectives. Is it time to reconsider the buy-versus-lease decision? If leasing remains the best option, can you negotiate shorter lease terms? Even if it’s not practical to negotiate a short-term lease (the lease standard has strict rules for what qualifies), estimating costs across a shorter time period can ease some of the burden of implementing the new standard.
You’re Not Alone
Another advantage of getting started early is the chance to get feedback from your financial auditors. While they cannot implement changes to your accounting processes and IT systems, they should be able to advise you and help keep you on the path to compliance. Most important, start to understand your portfolio of leases and the amount of leased assets and liabilities that will hit your balance sheet in 2020. As always, reach out to your CRI professional for guidance understanding and implementing the new lease accounting standard.