Accounting for disruption
The retail industry is no stranger to disruption. Ongoing challenges, such as changing consumer preferences, and the advent of e-commerce are simply facts of life for modern-day retail executives. A lesser known change of major importance soon to challenge the industry is the new lease accounting standards (ASC 842) put forth by the Financial Accounting Standards Board (FASB). ASC 842 was approved several years ago, but it takes effect January 2019 for public companies and January 2020 for private companies.
ASC 842 is a big deal for the retail industry because it requires retailers to record traditionally “off- balance sheet” operating leases onto their balance sheet. Since retailers have found the use of leases to be a cost-effective method for investing in stores, point-of-sale systems, distribution centers, and transportation equipment, the new ASC 842 standard will certainly have a significant impact. By some estimates, 35% of global retail entities will see their debt increase by more than 25%, with a median increase in debt of almost 100%.
Bringing leases onto the balance sheet can impact retailers in a myriad of ways, from budgeting and forecasting, to growth and acquisition planning; and if not calculated properly can put a company at material risk. As such, retail executives throughout the organization, including board members, need to fully understand the new rules and proactively implement tools and processes that will help them mitigate financial statement risk. It will also be critical to understand how much additional debt will be added to their balance sheets.
FINANCIAL IMPACTS AHEAD
The implications of ASC 842 promise to be far-reaching. For example, consider a retailer interested in securing institutional financing to fuel growth plans. If the retailer uses leasing as a financing tool, the company may find that the increased ASC 842 liability impacts how lenders view their debt to equity and debt service coverage ratios. Any debt covenants impacted would need to be uncovered and quantified as soon as possible, along with identifying strategic alternatives.
When it comes to budgeting and forecasting, impacts to the balance sheet need to be pointed out and explained to bankers and investors early on in the process to avoid any misunderstanding. It must be shown that the underlying business has not changed, with emphasis on how the new accounting rules impact financial ratios that banks and investors traditionally rely upon.
Timing is key. ASC 842 rules are effective for public business entities beginning after December 15, 2018 for the calendar period beginning January 1, 2019, whereas private companies have until after December 15, 2019, for the calendar period beginning January 1, 2020. If investors and/or banks inadvertently compare a business’s public retail business to a private entity, or vice versa over the next year, the conclusion drawn would be off. Therefore, it is important to ensure comparisons are accurate.
MANAGING MATERIAL WEAKNESSES
One of the biggest common concerns retailers have with ASC 842 adoption is risk of material weakness or misstatement. As with any computation that ends up on financial statements, the proper accounting controls must be in place. The challenge CPA firms, accounting departments, and tax departments run into is trying to interpret the ASC 842 written standard for the first time.
Prior to ASC 842, lessee retailers were not required to record operating leases on their balance sheets. Therefore, there exists a lack of documentation, process, and automation, all further complicating adoption of this new standard. Documentation and in some cases even the lease agreements are not always easily accessible. In many cases the processes and decision making surrounding lease management has been decentralized making fact finding, especially for the broader staff outside of the accounting and finance function, even more difficult. Gathering all relevant information for each lease is the first step to ASC 842 implementation and compliance.
Without the correct documentation, a member of the retailer’s staff may overlook and not record a critical lease component. Or an untrained staff person may incorrectly classify an operating lease as a finance lease, or vice versa. As with any financial transaction, putting a system in place that centralizes data and assists in lease classification is a key second step toward mitigating financial statement risks.
Since noncompliance may be flagged by auditors and disclosed to investors as a material misstatement, retailers must fortify their lease management process. When looking for an accurate, comprehensive solution for managing ASC 842 compliance, key criteria includes a system that has built-in document management with versioning, a full audit trail of decisions made, and proper permissions control to reduce risks.
The devil is in the details. The balance sheet can be impacted in multiple ways, such as by lease modifications that require re-measurement of the right of use (ROU) asset and/or liability, or by impairments. Some assessment questions to ask are: Will your staff know when these events happen, and when a re-measurement is required? Will they know how to compute the balance sheet impact? If not, putting a system in place that automates event alerts, determination, and re-measurement when required, is a powerful way to mitigate financial statement risks.
AN ASC 842 ACTION PLAN
As visibility is gained into how the new ASC 842 rules will impact retail businesses, companies should consider the following strategic steps to put themselves ahead of the financial curve:
- Governance — Appoint a cross-functional task force or team run by a project planner who has the authority to manage day to day details and report back.
- Current State — Have the task force or team assess the current state, and document all technological, operational and financial aspects of ASC 842.
- Improvements — Identify operational improvements and efficiencies that can be achieved as part of the ASC 842 adoption, as well as, any new financial controls and workflows.
- Lease vs. Buy — Review the current leasing strategy and whether moving from a lease arrangement to a fixed asset approach (with tax depreciation as a benefit) would be better.
- Automation — Analyze how existing systems can be improved and manual tasks automated. Determine if a specialized ASC 842 lease accounting software system would be beneficial, and if so, if it would need to connect to your existing ERP system?
- Timing — What is the implementation plan and when is your internal compliance deadline? When do you plan to go live? Will the relevant lease documents and data be gathered in time? How and when will the ASC 842 disclosures be prepared? These are just some of the questions that are critical to ensuring compliance. A system that specializes in ASC 842 can automate this process, and thereby, reduce financial statement risks.
Ensuring your company has the resources and tools necessary to compile and calculate comprehensive and accurate leasing data will not only assist in meeting compliance requirements, but also help executives adopt policies that will position them for long-term strategic success. In a world that depends on agility and lean operations, such payoffs are more than worth the effort. RL