Amazon earnings off another 1% due to real estate …. or so they would be if the new lease accounting was already in effect July 28, 2010
Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.Tags: Amazon, FAS13, FASB, IASB
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Earlier this week, I posted about Amazon’s disappointing results… about how the market reacted negatively to its increasing operating expenses and how real estate expenses likely are contributing to its higher-than-desired cost structure. Let’s take a look, though, at how expenses would have been even worse if the new lease accounting standard, being created by FASB and IASB, was in effect now.
(For a good review of the new accounting standard and its implications, see my webinar series which is available on-demand on TRIRIGA’s website.)
As I’ve posted previously, in the year that the new lease accounting is adopted, a company is going to see its lease-related expenses increase by 5% to 10% or even more where the remaining terms of leases are exceptionally long. We can use the operating lease obligation amounts shown in Amazon’s latest 10-K to estimate what the effect on Amazon will be.
The 10-K shows minimum operating lease obligation to be $162 M (2010), $146M (2011), $130 M (2012), $122 M (2013), $115 M (2014), and $317 M (2015+). Assume the last amount is actually distributed evenly over the years 2015 through 2019. For simplicity, we will ignore the fact that there may have been free rent periods or fixed rent increases that may make acrued expenses differ from cash flow. Let’s also assume that Amazon’s applicable incremental borrowing expense, which would be used to discount the obligations to determine how much lease obligation goes on the balance sheet, is 3.5%.
Under current accounting, none of the operating leases would be on the P&L, and the P&L expense for these operating leases would be $162 M for 2010.
Under the new accounting, though, Amazon would record an $850 M right-to-use asset on the asset-side of its balance sheet and an equivalent amount as a lease liability on the liablity-side. This will set in motion P&L accounting for the leases. There, if the new standard were in effect, Amazon would record expense of $174 M … an increase of $12 M over the expense under current accounting … or an increase of 7.5%. See chart, below.
The impact will be even more if Amazon’s leases have options to renew that are likely to be exercised. The obligations related to the renewal periods would also go onto Amazon’s balance sheet and, due to the way the accounting arithmetic works, result in an even higher expense in the first year of adoption of the accounting standard.
How would this $12 M affect Amazon’s bottom line? Let’s use, for illustration, the company’s Net Income for FY2009 of $902 M. This $12 M of additional expense, adjusting for taxes, would decrease net income by about 1% … not an insignificant number. To put the number in perspective, if the market were, therefore, to cut Amazon’s valuation by 1%, approximately $500 M of share value would be lost.
Whether one agrees with the logic of the new accounting or not, the financial effect is going to be something that cannot be ignored.
Current vs New Accounting for Amazon’s Existing Operating Lease Portfolio Clarification: The information in this chart shows the P&L impact of operating leases that existed as of 12.31.2009. It does not assume any renewal of those leases, nor does it make any assumptions regarding the signing of new leases.
| 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | |
| Current Accounting | ||||||
| Rent | 162 | 146 | 130 | 122 | 115 | 63 |
| Total | 162 | 146 | 130 | 122 | 115 | 63 |
| New Accounting | ||||||
| Depreciation | 144 | 128 | 113 | 106 | 99 | 53 |
| Interest | 30 | 25 | 21 | 17 | 14 | 10 |
| Total | 174 | 153 | 134 | 123 | 113 | 63 |
| % Increase | 7.5% |
Exposure Draft on New Lease Accounting To Be Out Week of August 9th July 26, 2010
Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.add a comment
The IASB has issued a podcast summary of the joint FASB/IASB board meeting for July. In it, they state that they are working towards issuing the Exposure Draft during the week of August 9th.
The Exposure Draft had been delayed so that the boards could agree upon the method by which lessors are to account for leases. There were two methods proposed: (1) Derecognition and (2) Performance Obligation. They decided to use the former where the risks of ownership have passed to the lessee and the latter where they had not.
Once the Exposure Draft is issued, interested parties will have until the end of Q4 /2010 to comment on its contents. These contents should not be a surprise, though, to those who have read the Discussion Draft of March 2009 and followed the subsequent deliberations of the accounting boards.
You can click on the “Lease Accounting” category on the navigation bar to the right to see my previous posts on lease accounting and how it will affect corporate real estate.
AMZN: Share prices fall due to rising operating expenses … on-line retailing isn’t asset-lite after all July 26, 2010
Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis.Tags: Amazon
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The Wall Street Journal reported last week in “Rising Costs Clip Amazon Shares” that Amazon’s “operating expenses … jumped 40% … triggering a sharp fall in its shares.” Investors were expecting soaring revenue numbers to result in a greater bottom line than they did.
To what extent did real estate contribute to this rise in operating expenses? Not too much if one just looks at the size of the real estate portfolio reported in the company’s 10-K’s. From FY2007 to FY2009, the square footage in Amazon’s “fulfillment and warehouse operations” portfolio grew by only 29% … vs 64% for revenue. That’s pretty good for an expanding company.
The growth in the company’s Fixed Assets is, though, another story. Fixed Assets grew, during that same time period, from $ .5 B to $ 1.3 B … an increase of 137%. Much of that is undoubtedly IT investments, but more than an insignificant portion may be investments in buildings to support operations. Depreciation charges are quickly rising.
And, the Fixed Asset build-up continues unabated. Fixed Assets rose from $1.3 B for FY2009 ending Dec 2009 to $1.7 B for the quarter ending June 2010, fueling even more depreciation.
This latest step-up in Fixed Assets may reflect Amazon’s putting in place the $278 M of “Construction in Progress” it had at the end of FY2009. And this is part of a larger story: Amazon has had quite a bit of real estate in the pipeline … 13 new fulfillment centers, to be exact … and this recent quarter may have been when their expenses started to hit the P&L. The next time Amazon reports the square footage of its portfolio, we’re likely to see it has increased substantially.
Now … it may be that Amazon is just investing ahead of sales. Real estate is notoriously “lumpy”. You can’t add space gradually as sales grow. You need to build large blocks of space ahead of growth.
This is, though, all a bit disappointing to those who think the on-line sales model can be supported by an asset-lite infrastructure. It seems that a lot of space is needed to offer next-day-delivery for all those books and electronics gear.
Irony of ironies: I’m wondering if, when Amazon looked for space for its fulfillment centers, it looked at some of the large empty spaces showing up in shopping malls as a result of people shopping on-line.
I remember the Amazon TV commercial from a few years ago .. the one with the guys measuring various big buildings … like, if I recall correctly, the Roman Colosseum and domed stadiums … to see if they were big enough to hold the “Amazon store”. Seems it was closer to the truth than we thought.
| FY ending: | 2007 | 2008 | 2009 | % increase 2007 to 2009 |
| Revenue | $ 14.8 B | $ 19.1 B | $ 24.5 B | 64% |
| Sq Ft – “Fulfillment and warehouse operations” | 13.6 M | 17.3 M | 17.6 M | 29% |
| Sq Ft – all | 15.8 M | 19.7 M | 20.3 M | 29% |
| Fixed Assets | $ 543 M | $ 854 M | $ 1,290 M | 137% |
New Lease Accounting Influences Northrop Grumman to Buy HQ July 21, 2010
Posted by Bob Cook in Corporate HQ, Financial Planning & Analysis, Lease Accounting.Tags: Corporate HQ, Corporate Real Estate, FAS13, FASB, IASB, Lease Accounting, Northrop Grumman
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Soon-to-be HQ
Today, The Wall Street Journal announced its “Deal of the Week” to be the Northrop Grumman purchase of a new headquarters building in Falls Church VA. In “Northrop Is Flying East”, the WSJ writes that the company “looks to have gotten a pretty good deal” but that “Northrop also took into consideration the low cost of borrowing money and proposed new accounting standards that could make it less advantageous to lease real estate” (emphasis added for this post).
It is, of course, no coincidence that I’ve been proselytizing on the impact of the new accounting and that Northrop is one of my consulting clients.
Expect to see more such transactions from other companies as the impact of the accounting standards become clearer to those in corporate real estate.
Read more posts about lease accounting here.
Lease expenses up 5 to 15% … how to manage the budget effect of the new lease accounting July 21, 2010
Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Lease Accounting.3 comments
The desire for better disclosure of lease liabilities on financial statements is driving the accounting change, but that change is going to have many “downstream effects”. The most painful one may be the impact on corporate real estate budgets.
I’m not talking about the budget that will be required to put in place the processes and systems to comply with the new standard … although that, granted, will also be painful … but rather, I refer to the fact that, in the first year of adoption of the new standard, corporate real estate departments are going to find their previous budgets to be woefully short of what’s needed to cover their lease expenses.
How you may feel if you don't manage the challenge
Description of the new accounting
Why is this going to happen? While the main goal of the new accounting is to provide better disclosure of leases by putting them on the balance sheet … as both a right-to-use asset and as a lease liability … this balance sheet accounting sets in motion a whole new way of accounting for lease expenses on the P&L.
The simple concept of a “rent expense” will be a thing of the past. Instead, leases will have a “depreciation expense” and an “interest expense”. The result will be that P&L expenses resulting from a lease early in the obligation will be much higher than those later … and important to know regarding budgeting, they will be higher in the early years than they would be in those same years under present accounting.
For a more complete description of the accounting and its implications, check out my webinars held on behalf of Tririga. They are available on-demand on Trirga’s website.
The Budget Challenge
An illustration: Take a ten year lease with a $1 million annual rent obligation. Under present accounting, you would simply have a $1 million “rent expense”. Under the new accounting, assuming a company incremental cost of debt of 6% used to discount obligations to determine balance sheet amounts, you will have a “depreciation expense” of $736K and an “interest expense” of $442K, for a total of nearly $1.2 million … an increase of almost 20%!
And because your company probably structures internal budgets to parallel P&L expenses, your budget to cover leases in the first year of that lease will have to be higher than what it would have been under the present accounting by that-nearly 20%.
Now … you may be thinking, “That’s ok, I’ll just make sure I put that higher budget in place and make sure my internal client understands it before I sign the lease.” Well … if that hasn’t gotten your nervous system jittery yet … consider this: Most likely, the new accounting standard will not allow grandfathering of existing leases. At the time your company adopts the new standard, you will have to account for all your operating leases as if they were new on that date.
The result: The P&L expense of each and every lease in the portfolio will instantly increase. Your overall portfolio expense won’t go up by 20% unless all your remaining lease terms are ten years or longer, but the increase is still likely to be significant. Depending upon the length of the remaining lease terms at the time of adoption of the new standard, your budget for your lease portfolio will probably have to go up somewhere between 5% and 15%.
What can be done?
So.. can anything be done to ameliorate the budget impact? Yes and no. The phenomenon of P&L expenses being very high at the beginning of a lease and higher than they would have been under the existing accounting is inevitable. There are, however, at least three things that can be done to ameliorate the budget impact.
The first is to not let yourself and your stakeholders be surprised by this budget problem. Begin planning for it now. Most companies plan budgets 12 to 18 months in advance. With the adoption of the new standards likely, in my opinion, in 2013, this means you are less than a year away from having to include the new accounting in your budgeting. Begin now to understand the impact on your company and communicate it to stakeholders.
The second thing that can be done is to re-structure your lease portfolio over the next few years so that you will not have a large number of leases with long remaining terms when the new accounting is adopted. Clearly, this is easier said (or written) than done. Your first priority is to base portfolio planning on company needs to adequately control space and have flexibility where needed, and the second is to base leasing decisions on market conditions. After considering these, though, plan on incorporating this portfolio planning goal of minimizing remaining lease terms in your lease negotiations and re-negotiations.
The third thing to do is to prepare consolidation plans asap so that you’ll be able to assume that you will not be exercising some of your options to renew leases. This will avoid having to account for long lease terms because option periods need to be included if options are likely to be exercised. This will significantly decrease the budget challenge in the year of adoption of the new accounting. I’ve written previously of how adopting alternative workplace strategies might let you justify consolidation plans and reduce the financial statement impact of the new accounting. So, too, would other actions that would allow consolidations, such as outsourcing business processes, moving sales to the internet to reduce sales or retail space, or just rationalizing a portfolio to excise excess space.
Start now
As is the case with everything having to do with the new lease accounting … from reformulating real estate strategies to preparing new processes for compliance … you need to start now. Don’t get lulled into thinking this is something that does not have to be addressed until the standard is in place. Actions you are taking today will probably not be grandfathered. For all practical purposes, the new standard is already in play.
Your favorite corporate real estate websites and blogs? July 16, 2010
Posted by Bob Cook in Profession of Corporate Real Estate.add a comment
I’d like to augment my blog roll … that is the links I provide at the lower part of the sidebar … by including more worthy blogs and websites that cover corporate real estate topics. Please comment as to which sites you’ve found helpful, and I’ll share them with others via my blog roll. I don’t promise that I’ll include them all, but I’ll try to include those that seem particularly valuable. … And, “yes”, you can recommend your own site if you’d like.
Also, please note that you can subscribe to this blog via email. There’s a link to sign-up near the top of the sidebar. It’s a good way to keep up-to-date on the topics I cover.
Alternative Workplace Strategy’s New Best Friend: The New Lease Accounting July 12, 2010
Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.Tags: FAS13, FASB, IASB
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How is that? How could lease accounting impact workplace strategy?
If you’ve been reading this blog … or if you’ve tuned into my lease-accounting webinars (which are available on-demand on Tririga’s website), you’re already aware about how the new lease accounting is going to have implications far beyond accounting… about how it’s going to shine a huge spotlight on corporate real estate, force a re-thinking of real estate strategies, and require creation of new processes, systems and careers. Alternative Workplace Strategy is an area where all three of these effects will come to play at once.
Many companies have nascent programs to implement Alternative Workplace Strategies … such as office hoteling and work-from-home … but many of these programs just haven’t gotten very far. While these programs have as their goals worker productivity and satisfaction gains, the bugaboo is usually around a companion goal to save money, to show a positive ROI from cost savings. There seems to be a Catch-22: it’s difficult to show a positive ROI on a single implementation because you usually need the mass of many implementations before net cost savings can be shown … but without an ROI-positive demonstration pilot, most companies are leery to commit to the many implementations needed to show a positive ROI.
The new lease accounting, though, provides a way around this conundrum. To see how, I need to explain a bit of the new accounting….
Basically, the present value of all likely lease obligations will be going onto company balance sheets to better inform the public about the financial obligations of companies. The operative word for this discussion is “likely”. If you have a lease with a right to renew, you will have to decide whether it is likely that you will be renewing the lease or unlikely. If you decide “likely”, the lease payments due during the renewal period(s) need to be included in the present value calculation. This will increase the amount that goes on the balance sheet … something that company managements won’t like because it will make their companies look more risky to investors and will, at least in the early years of the new accounting, hurt their P&L. Company managements will want to assume renewals are unlikely, but auditors will be closely scrutinizing the renewal vs non-renewal assumptions. Managements will have to substantiate their assumptions.
And because of the spotlight the new lease accounting is going to shine on lease obligations, assumption-making about leases is going to get upper management attention … as will the real estate strategies that affect the amount of those obligations. Among these, Alternative Workplace Strategy is one that can make a big difference.
Think about it. If a company were to commit to the “likely” implementation of an Alternative Workplace Strategy and if that strategy allowed it to reduce its space and plan to forgo renewing some of its leases, it should be able to assume those leases will not be renewed. Voila….the company would avoid including the renewal period obligations on the balance sheet.
Now, the commitment would have to be sincere. Auditors would want to see evidence that, in fact, the company has set the course to implement the Alternative Workplace Strategy. They’d want to see demonstration projects, budgets, detailed plans, implementation processes, ROI calculations, executive sponsorship, etc. But if a company can show these things … my oh my … just a commitment to implementing an Alternative Workplace Strategy will create an immediate financial-statement benefit!
That’s why I’m saying, “Alternative Workplace Strategy, meet your new best friend …. The New Lease Accounting.”
FacilityZone.com might serve industry well … but then, again, maybe not July 9, 2010
Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.add a comment
Like many in corporate real estate, I received an email announcing a new search engine, FacilityZone.com, which has a tagline: “The power of Google technology, results for facility professionals. I took it for a drive and had mixed results… although, my criteria were, admittedly, a bit self-centered.
I tested the search engine by doing searches on both it and Google.com to see how the results differed. My search terms were those near and dear to my heart. Here’s the results…
Search: Lease Accounting
“Lease Accounting” (with no quotes) was my first test case. On FacilityZone.com, lo and behold, the very first entry was “Tririga Webinar: The New Lease Accounting Standards and You” which links to registration for a webinar series that I have recently conducted for Tririga (and which can be heard/viewed on-demand on Tririga’s website). When I entered the same search in Google.com, I couldn’t find the Tririga webinar anywhere on the first five pages. I started getting excited about FacilityZone.com.
Search: Corporate Real Estate Strategy Blog
I then wanted to see where this blog you are reading might show up. I typed in “Corporate Real Estate Strategy Blog” (again, with no quotes). On FacilityZone.com, to my disappointment, it did not appear at all on any of the four pages of results. But when I did the same search on Google.com, this blog appeared at the top of the list. Go figure.
Try your own tests. I’d be interested in hearing the results.
Exposure Draft on Lease Accounting Is Delayed … but Companies Can’t Get Lulled into Delaying Response July 6, 2010
Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.Tags: FAS13, FASB, IASB
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Addendum: On August 17, 2010, IASB and FASB issued the Exposure Draft on Leases. See my post of that date and links to the ED here.
Also, see my other blog posts on the new lease accounting here.
Well… June has come and gone. The IASB and FASB had targeted June for the release of the Exposure Draft on the new lease accounting. It’s not out yet. Both organizations have, in the last week, posted revisions on their websites that state the Exposure Draft will be out in Q3 of this year (instead of Q2) with a comment period to go through Q4 (instead of Q3). See the lease accounting project websites for FASB and IASB. Also, see FASB’s timeline for all projects.
Why the delay? The main thrust of the new accounting is aimed at how lessees (aka tenants) should account of their lease obligations. The delay is apparently due to the accounting boards deciding that they needed to get some closure on how accounting for lessors (aka landlords) would work and then finding that the lessor accounting issues were thornier than they originally thought. Observers are guessing that the Exposure Draft will be out either this month or next month.
New lessee accounting is already pretty clear, though. For those who have been following the accounting board’s deliberations over the last few months, the contents of the Exposure Draft will not be a surprise. In March 2009, the boards issued a Discussion Paper that outlined the overall concept of the new accounting … which requires all leases to be put on the balance sheet … and the notes from the monthly Lease Project meetings that have subsequently been taking place address various details of the accounting and can be viewed on the IASB website. At this point, it is possible to have a pretty good understanding of what will be in the Exposure Draft … at least as it relates to lessee accounting.
Exposure Draft delay will probably not delay the issuance of final standard. It is important to note that there is no delay expected for the issuance of the Final Standard which is due out by June 2011. Compliance would be due sometime after that. The Effective Date of the standard is not known yet, and during the comment period, corporations are likely to request a long transition period to allow them to put in place the new processes and systems that will be required. The Effective Date on which the accounting will be required will probably be in 2012 or 2013, but it could be later.
Don’t be lulled into delaying response. Many companies are delaying applying resources to respond to the new accounting until the Exposure Draft is out. This is typically how companies approach new accounting standards, and it usually makes sense … but maybe not this time. Here are two reasons why…..
New processes will take time to establish. First, in order to be able to comply with the new lease accounting standard, companies are going to have to do a lot more work than is usual when a new standard is issued. Most new standards simply require that financial information which is already available be accounted for differently. That only requires an adjustment at the end of the overall accounting process. In the case of the new lease accounting, however, the processes needed to gather and record some of the required information don’t even exist yet in most companies. New processes are going to have to be designed, documented, implemented, tested, and revised prior to the Effective Date. This is a lot of work. Companies that wait too long to get started on this are going to find themselves in a frenzy at the end. (Remember Y2K? Or the initial SOX-compliance?)
Grandfathering is unlikely. The second reason responding to the new lease accounting should not be delayed is that grandfathering is extremely unlikely. Leases being signed today will probably have to be accounted for under the new lease accounting once the new standards are required. Companies should already be taking the new lease accounting into account when evaluating decisions like length-of-lease or own-vs-lease. Companies that are not already doing so are already behind in addressing the new standard.
Waiting for the Exposure Draft. While it makes sense to wait for the Exposure Draft to be released before “pulling out all the stops”, getting started now on responding to the new standard would be prudent for most companies. Whatever amount of time will be available between issuance of the Exposure Draft and the Effective Date of the new standards is sure to seem like too little. In order to ease the time crunch that is surely coming, companies should now, at the minimum, mobilize to respond to the new standard by learning more about the standard and by establishing teams and point people to lead the effort ahead. That effort is going to require addressing everything from real estate strategy to new process design to structure of the real estate function.
Tririga Webinars. I’ve completed a series of webinars, sponsored by Tririga, on “The New Lease Accounting and You”. There I spoke extensively about how the new standards are going to change how corporate real estate is done, how it’s impact will go far beyond how accounting entries are made. If you missed hearing these webinars live, you can register to hear them on-demand on Tririga’s website.
Corporate Real Estate Strategy 