Lease Rule Would Hit Profits

NOVEMBER 16, 2011 The Wall Street Journal

Lease Rule Would Hit Profits

By EMILY CHASAN

Retailers, banks and airlines, which often use long-term leases to add to their locations or aircraft fleets, are pushing back against a proposed accounting rule that would act as a drag on their profits.

U.S. and international accounting-standards setters appear ready to reconsider the proposed rule, which has emerged as the most controversial piece of their effort to overhaul accounting rules for leases. The outcome could influence the length of commercial leases, how fast some companies grow and how much exposure they might have to the real-estate market.

Wal-Mart Stores Inc., the world's No. 1 retailer, and drugstore operators Walgreen Co. and CVS Caremark Corp. are among the big companies that could be hit hardest by the proposed rule, part of a long-term project by the U.S. Financial Accounting Standards Board and its overseas counterpart, the International Accounting Standards Board, to make balance sheets more accurately reflect a company's assets and liabilities.

The overhaul aims to address complaints that current accounting rules let companies leave investors in the dark about the size of their lease obligations. Many companies keep most of these obligations off their balance sheets, disclosing only a few details in financial footnotes.

Most American companies are resigned to the centerpiece of the overhaul: treating leases—or the right to use a piece of property or equipment—as a new kind of asset. This new asset would be offset on a company's balance sheet by a corresponding liability, the obligation to pay rent. The change would add a total of $1.7 trillion in current liabilities to corporate balance sheets world-wide, according to analyst estimates.

However, companies are at odds with the standards setters over how lease expenses should be recorded on their books. As the proposal stands, companies would have to use a method called front-loading, which effectively concentrates the cost of a lease into its early years. Currently, they can spread the average rental cost under a lease evenly over its lifetime, often as long as 20 or 25 years.

"The [FASB] staff is currently evaluating at what time we might bring [the front-loading] topic back to the board table," said Kristin Bauer, an FASB practice fellow who works on the lease-accounting project. That could happen as early as December at a joint meeting in London with the IASB.

Leases generally are more valuable to retailers in later years, after a location has built a following and is generating more cash. If forced to adopt front-loading, retailers argue, they would have to book higher costs for a new store before its sales have had a chance to take off.

If a retailer was expanding, signing new leases faster than its old ones expired, front-loading could take a heavy toll on profits.

Similarly, front-loading could weigh down profits for years at banks that have lots of retail branches. Airlines, which have razor-thin profit margins and use aircraft leases to hold down costs, also are worried about the impact on their bottom lines.

Based on companies' current disclosures about leases, Bill Bosco, a member of the IASB's working group on lease accounting, estimates that big retailers that use long-term leases, such as Walgreen, CVS, and Wal-Mart, would book higher lease expenses for eight to 15 years under the new proposal than they would using the current straight-line method.

Walgreen would be the most-affected of the three, with a 23% increase in lease expenses in the first year alone, said Mr. Bosco, who also works with the Equipment Leasing and Finance Association.

A representative of Walgreen, which leases about 79% of its locations and typically signs 20- to 25-year leases, said the front-loading issue is the "most sensitive" area of the proposed changes for retailers, because the expensing method doesn't reflect the way leases work.

Walgreen wouldn't comment specifically on Mr. Bosco's estimate, but pointed to regulatory filings in which the company said the proposed changes would have a material impact on its financial statements.

Wal-Mart and CVS declined to comment.

In a December letter to the FASB, CVS said it leases 95% of its retail stores under long-term leases and has $26.9 billion in operating-lease commitments. It said it would need to hire additional finance personnel to handle the proposed rule's "onerous" requirements.

Nor do investors generally favor front-loading. "Many investors like the straight-line approach," said Janet Pegg, an accounting analyst at UBS AG in New York. "They feel it more accurately depicts cash flows."

Companies could potentially shorten the length of their leases in order to keep the overall cost down, and so minimize the expenses they record, said Bret Hardy, head of corporate finance for commercial-real-estate firm Colliers International.

But, if companies were to shorten leases, that would require more-frequent renewals, leaving them more exposed to swings in the real-estate market, according to Credit Suisse accounting analyst David Zion.

Printed in The Wall Street Journal, page B5

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