Amazon earnings off another 1% due to real estate …. or so they would be if the new lease accounting was already in effect

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%