The FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) recently announced a joint project to rewrite the lease accounting standard. The FASB and IASB have tentatively concluded that virtually all leases should be reported on the balance sheet. But most leases are currently considered off balance sheet financing. In an recent interview conducted by Chain Store Age, they explain how these new rules could impact retailers in a big way.

For example, a majority of store leases set by retailers can be 15 or more years, especially if you are including renewal options. But they are often structured as operating leases. By treating these now as capital leases, the impact on the balance sheet could be substantial.

Georgia Tech recently conducted a study showing the potential impact on retail companies. They estimated a median 5.3% decline in reported earnings for fiscal year 2006. The impact on the balance sheet was considerably greater: 14.6% increase in assets, 26.4% increase in liabilities. This would be a significant hit to financial ratios. These changes may mean that growth requires more capital to meet loan covenants and investor expectations. For some companies, the effect could be several times the median, depending on how they do their leasing.

FASB plans are expected to release an exposure draft later this year with a final standard in 2009. Projections when this would take effect could occur at the start of 2011. For retailers in strong financial positions, the consideration of whether they should lease-vs.-buy could tilt more to buying real estate. According to reports, there is a large discrepancy between reporting; some retailers report a large number of capital leases or owned stores, while others have none. As a result, these changes could be viewed as good or bad depending on your organizational structure.

Operating expenses are the cost incurred in operating and maintaining a property.  Such cost can include maintenance, repairs, utilities, landscaping, security, snow removal, management fees, property taxes and insurance.  The lease will define which costs are included in a tenant’s prorate share.

Lease Language 

The language in the lease surrounding the calculation of the tenant’s CAM expense can be very complex.  There are often very specific provisions for capping certain expenses, varying prorata shares per expense type, gross up calculations and the calculation of Base Year.

Operating expenses are often capped based on whether expenses are controllable or uncontrollable.  The lease should define specifically which expenses fall into each of these categories and/or which expenses the cap is applied to.  Typical uncontrollable expenses can include real estate taxes, utilities and/or insurance.  Landlords will likely exclude these expenses from the cap calculation since the cost of these items are something the landlord has very little control over.  Leases may even include a different percentage increase allowed on certain line items as opposed to a flat percentage increase on all capped expenses.  The calculation of a tenant’s prorate share can vary for certain expenses.  You will likely see this in properties where larger tenants pay certain expenses directly or where there is a high use by a certain type of tenant such as restaurants who have a high volume of rubbish removal in comparison to the other tenants.  Additionally, the cap calculation can be a cumulative calculation or based on prior year expenses.  Landlords must carefully scrutinize their gross up calculations to ensure expenses are recognized in the appropriate reconciliation period and based on the occupancy level if allowed per the lease.  Otherwise they may be setting a low base amount for the next year’s cap calculation.

Tenants – Opportunity for Savings 

Because of the amount of detail surrounding the calculation of operating expenses, this is an area of huge potential savings for tenants.  It is the burden of the tenant to ensure that their prorate share of expenses are being properly calculated by the landlord who may have distinct lease language for many tenants in a property thus increasing the likelihood of a mistake.  This not only includes the mathematical equation of the calculation but will require the appropriate back up documentation to validate the accuracy of the expenses being passed through.
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