Lease expenses up 5 to 15% … how to manage the budget effect of the new lease accounting July 21, 2010Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Lease Accounting.
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.
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.
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.