NEW YORK — When it comes to accounting for leases, the loopholes are gone, thanks to a group of bean counters who urged the Securities and Exchange Commission to clarify the rules.
The clarification forced retailers and other public companies, such as restaurants, who lease retail space to change their accounting methods.
Although widespread in the retail industry, the change in accounting is seen as having little impact on results. So far, retailers have said the clarification ended up slicing off a penny or two from their earnings per share.
“This is just closing loopholes,” said Patrick Breslin, senior managing director of retail at GVA Williams, a Manhattan brokerage who added that companies had been getting “very creative when it comes to their real estate accounting.”
One retail analyst with a Wall Street brokerage, who asked not to be identified, said, “if it’s not a cash thing, I don’t care all that much. To me, it’s just a nuance.”
Responding to a request from the American Institute of Certified Public Accountants, the Securities and Exchange Commission issued a letter on Feb. 7 clarifying its interpretation of generally accepted accounting principles related to operating leases with respect to the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 13 Accounting for Leases, initially published in 1976.
The letter, which was sent to Robert Kueppers, chairman of the Center for Public Company Audit Firms at the AICPA, from Donald Nicolaisen, chief accountant at the SEC, clarified accounting for amortization of leasehold improvements, rent holidays and landlord-tenant incentives.
According to a person familiar with the matter, questions concerning accounting for store operating leases first arose in November 2004 when the financial auditor of a publicly traded restaurant company found inadvertent accounting inaccuracies in a quarterly report — one being the term by which the company amortized leasehold improvements.
By early January, when most publicly traded companies were preparing their year-end financial reports, a group of the nation’s largest financial auditing firms realized it was more than just one or two companies that had done the lease accounting incorrectly, this person said.
That’s when the AICPA requested the SEC to compose a letter addressing the three biggest issues pertaining to lease accounting. The challenge was to have companies address these accounting issues before they filed year-end 10-K reports.
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In the letter, the SEC first addressed the way companies have allocated the cost of improvements to leased properties. Nicolaisen wrote that leasehold improvements “should be amortized by the lessee over the shorter of their economic lives or the lease term.”
Companies had been reporting rent expense and/or leasehold amortization that understates expenses.
Take a company that has a 10-year lease on one store with the option to renew it once for another 10 years, which would total 20 years. If the lessee makes $200 in improvements to the location, it must amortize that $200 over the 10 years of the original lease, rather than the possible 20 years. Amortizing it over the longer time frame, as many companies had been doing, made the rent expense smaller each year and thereby benefited net income.
Regarding accounting for rent holidays — periods when rent is free or reduced — Nicolaisen clarified that lessees should use the straight-line accounting method over the lease term, including any rent holiday periods. The straight-line basis is a method of depreciation that allocates the cost of tangible assets, such as buildings or machinery, over the life of the asset.
Retailers may have been taking the rent holidays sooner rather than spreading the total holiday over the life of the lease. Applying rent holiday benefits earlier can inflate earnings.
For many retailers, this means they must change their straight-line accounting to include the construction period of leasehold improvements as rent expense over the lease term. Urban Outfitters Inc., for example, said in its fourth-quarter earnings report that it has historically used straight-line accounting to record rent expense over the lease period, starting the date the store opened, which did not include the construction period for when the leased space was improved.
As John Kyees, chief financial officer of Urban Outfitters, explained during the company’s quarterly conference call: “The SEC indicates that rent expense should be recognized even when the store is under construction and the company is not allowed to occupy the space for retail purposes.”
Kohl’s Corp. is restating its financial statements beginning with fiscal 1998 through the first three quarters of 2004 to recognize rent expense on a straight-line basis over the expected term of the lease. Historically, the company had recorded rent expense on a straight-line basis over the initial lease term with the term beginning when actual rent payments began.
Kohl’s restatement accounts for decreases in diluted net earnings per share ranging from 1 cent to 3 cents from 1998-2003. In the first three quarters of 2004, diluted net earnings per share is 1 cent lower each quarter. For four-quarter 2004, the impact on net income is expected to be $2 million and earnings per share will decrease 3 cents.
The third part of the clarification is in regard to landlord-tenant incentives, or allowances. Nicolaisen said any leasehold improvements made by lessees and funded by landlord incentives should be recorded as leasehold improvement assets and amortized over a term of “the shorter of their economic lives.”
“It is inappropriate to net the deferred rent against the leasehold improvements,” Nicolaisen wrote.
For example, if a landlord says it will pay $500 toward a tenant’s store set-up costs, such as signage and fixtures that will total $1,200, the lessee should report a $1,200 asset on its balance sheet and a $500 liability for the amount of cash received from the landlord, rather than reporting an asset of $700. In other words, the tenant should show both its liability and its asset, rather than the net affect of both.