Posted on CoStar.com | April 17, 2019
Liabilities, Higher Occupancy Costs on Balance Sheets Prompt Firms to Own Land or Shorten Terms
Cedar Fair Entertainment Co. agreed to buy the land under its Great America amusement park in Santa Clara, California, for $150 million not only to get control of the 112 acres. It’s also coping with a $3 trillion accounting rules change rippling across corporate America.
Cedar Fair currently leases the land from the city of Santa Clara through a long-term agreement. However, it had to reassess that lease because of new lease accounting rules required by standard-setting groups that kicked in this year for publicly traded companies.
Operating leases are contracts that allow the use of an asset without conveying ownership rights. Operating leases are counted as off-balance sheet financing and, as a result, have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets.
The new rules require companies to report lease assets such as properties or equipment, and lease liabilities – essentially rent payments – on their balance sheets. They also require additional disclosures regarding the amount, timing, and uncertainty of cash flows arising from leases. Previously, companies could simply list lease transactions in footnotes in their financial reports.
The rule change could bring nearly $3 trillion of liabilities onto the balance sheets of U.S. companies, according to the International Accounting Standards Board. In an effort to regulate corporate accounting scandals highlighted by the collapse of Houston energy giant Enron, the IASB and its U.S. counterpart, the Financial Accounting Standards Board, adopted the rule in 2016 to improve transparency in reporting the financial impact of lease transactions on companies’ bottom lines.
The standard takes effect for private companies for the 2020 fiscal or calendar year.
For Cedar Fair, those new accounting rules were expected to result in the recognition of lease liabilities between $65 million and $75 million for its Santa Clara land lease, as well as its other operating leases.
If the deal to acquire the land goes through, Cedar Fair anticipates the remaining operating lease commitments would be immaterial to the consolidated financial statements, the company reported in its annual report with the Securities & Exchange Commission.
Companies across the country are having to deal with the impact of the new rules.
“The challenge for companies of getting the lease accounting transition completed was much greater than most anticipated,” said Andy Thomas, president of CoStar Real Estate Manager. “They were not in as good of shape with their lease data, making it a challenge.”
Nor did they fully understand what they would need to meet their financial reporting requirements, Thomas added.
“The biggest impact will be that chief financial officers will focus more on how they are managing their real estate and equipment leases due to the looming presence of the lease liability now on their balance sheets,” he said. “The actual impact on earnings for companies is likely to be very modest, on average.”
Companies have started reporting widespread consequences, even for deals that happened years ago.
Sportsman’s Warehouse Holdings reported that it would no longer be amortizing the deferred gain from a 2012 sale-leaseback transaction. It now expects its occupancy expense to increase by about $1.4 million, reducing its earnings per share by 2 cents for fiscal 2019. Its estimated total earnings per share is 59 cents.
Del Taco Restaurants lowered its projected earnings for the year by $3.5 million to between $66.5 million and $69.0 million compared to a range of $70.0 million to $72.5 million as a result of the changes.
Not all of the changes are negative. Kohl’s adopted the new rules in February. The department store chain reported the move is expected to result in the recording of additional assets and liabilities of about $2 billion but will boost 2019 net income by approximately $5 million.
“The immediate impact is on lessees who are adjusting their balance sheets to reflect the increased assets and liabilities,” said Veronica Bulman, senior manager at RSM, a network of independent audit, tax and consulting firms, in a statement. “That’s a large undertaking, particularly for those companies with a high volume of geographically scattered leases.”
Bulman said the changes also could accelerate the shift away from long-term leases.
The commercial real estate industry has been experiencing a pullback from long-term leases as companies increasingly demand flexible space to accommodate quickly changing business needs. Retailers have scaled back their brick-and-mortar operations in favor of pop-up stores and other experiential models; office tenants have been experimenting with shared-space providers such as WeWork.
“While the bookkeeping requirements of long-term leases under the rule require significant data tracking, companies can avoid the issue entirely by moving to short-term leases,” Bulman said. “As their leases come up for renewal, companies may choose to enter into short-term leases and annually reassess whether traditional office space or brick-and-mortar storefronts make sense for their business.”