Chipotle Mexican Grill Inc. and accessory brand Fossil Group Inc. were among the restaurants and retailers seeking rent concessions this spring to ease cash flow as stay-at-home orders slammed their businesses.
Businesses may appreciate the rent breaks, but they are another burden for accountants during an already tricky time for financial reporting. Lease accounting rules changed last year, forcing companies to track the value of leased assets like airplanes and warehouses.
Calculating current values of changing lease terms during an evolving pandemic may be some of the hardest accounting companies have ever faced.
“It’s a perfect storm of things coming together that makes this such a problem,” said Bruce Pounder, who runs the technical accounting advisory firm GAAP Lab.
Other major U.S. retailers and restaurants, including Burlington Stores Inc. and Cheesecake Factory Inc., have also said they were looking to renegotiate rent payments.
Lower rent collections by landlords reflect that trend. Shopping centers reported that rent collections dropped below 50% in April. In comparison, industrial and office tenants generally paid in full and on time, according to a Morgan Stanley analysis.
Those long-term obligations are critical to investors, who have been poring over balance sheets since March to weigh which companies will survive the pandemic and the economic tailspin.
Wave of Modifications
Under the new lease accounting standard, companies must update leased asset and liability values regularly. That means that as new leases are added, old agreements end, or terms are extended, a company has to recalculate how much it will owe over the life of a contract.
The recalculations were expected to occur piecemeal, maybe a few updates every quarter. But the sudden economic downturn has accelerated the changes.
On top of that, as shutdowns stretch into June, companies are reevaluating their future needs. Will they need all the shop and office space they have now? And that increases the volume of work needed for lease accounting.
“Where you may have been doing this here and there, you now may be doing it for all of your leases,” said Dominick Kerr, accounting partner with the Connor Group.
The firm is fielding more and more calls about applying the still-new rules. More sophisticated clients need help running scenarios, and smaller clients want the firm to handle the calculations for them.
Like Kerr, Ane Ohm, CEO of software provider LeaseCrunch, has seen a spike in interest from public companies that thought they could manage their lease modifications and recalculations in a spreadsheet. Many companies just wrapped up annual audits and realize they need to be able to document changes in the lease terms, and do it all within tight financial reporting controls, Ohm said.
Manual workarounds like spreadsheets have buckled under the volume and pace of rent payment changes, she said.
One of the biggest challenges facing businesses now is whether small, one-time rent deferrals, like those sought by Chipotle and Fossil, require a complete reassessment of an individual lease.
In response to pleas from retailers, the Financial Accounting Standards Board provided some relief in April, telling companies that they could instead book those temporary changes as a reduction in expenses on the income statement for the quarter and leave the lease liability alone.
It’s a double win, reducing the workload and allowing companies to offset their depleted revenue. The accounting reflects what’s happening today, instead of making what may be an ultimately immaterial adjustment to the total amount due over the life of the lease, Ohm said.
Zahilys Hernandez-Perez, chief financial officer for the National Retail Federation, called the relief a practical solution that landed as retail accounting teams were preparing first quarter reports. Still, she said there’s plenty of other work.
That to-do list includes writing fresh disclosures, evaluating how changes in credit and interest rates could alter discount rates used to calculate the liability, reassessing the fair value of the leased assets, and reviewing potential asset write-downs, Hernandez-Perez said in a statement to Bloomberg Tax.
Despite the optional reprieve, some companies may still choose to recalculate their lease liabilities to make their balance sheets more attractive to lenders and investors.
Switching the payment from a fixed rent to variable rent—based on sales, for example—would remove a lease from the balance sheet. That would bring down the total liability, possibly helping cash-strapped companies stay within their debt covenants, said Anastasia Economos, a financial accounting partner with Ernst & Young LLP.
Companies also may opt to recalculate the liability in order to take advantage of a better discount rate, which could reduce the balance sheet obligation and help improve coverage ratios, she said.
Impairment testing is yet another aspect of lease accounting that is also weighing on companies. Under the new rules, leased assets are subject to impairment testing just like goodwill and other long-held assets, but in the current economic climate that could become much more commonplace than the small or infrequent writedowns recorded so far.
“As long as your business is closed, you have an indicator of impairment that you need to assess,” Economos said.
Companies are doing their best to come up with cash flow forecasts and to estimate fair values. But if the recovery they predict in those estimates doesn’t materialize, then they may have to take another look at the calculations, she said.
Industries with large lease obligations, like airlines, hospitality, and retail, are more likely than others to have to book impairment charges in the coming quarters. They could be materially significant and bring down earnings, Pounder said.
All that work to bring leases onto the balance sheet over the past two years may be paying off in one way, however.
Armed with key details about a major driver of a company’s equity, chief financial officers are using that information to their advantage during the crisis as they go to the bank looking for new lines of credit or to negotiate with a landlord.
“These companies are desperate for liquidity, and having the leasing information at their fingerprints enables them to have effective conversations with their landlords,” said Marc Betesh, CEO of Visual Lease, a provider of lease accounting software.