In the Store | June 2011 | By John Morell

Fleeced by a Lease

Restaurant operators might soon have to list lease costs clearly on their balance sheets, a move that could drastically affect the real-estate market in the coming years.

Operators could struggle to find financing if proposed lease rules take hold.
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It’s always been difficult to own and operate a successful quick serve, and in the next few years, it might get tougher. That’s because some proposed rule changes in the way a company’s balance sheets are organized could create mayhem by showing that, on paper at least, a profitable quick-serve unit is losing money.

“The greatest effect will be on businesses like quick serves and retail chains with lots of locations and real-estate leases,” says Dwayne Shackelford, a principal with Huntley, Mullaney, Spargo & Sullivan, a real-estate consultancy based in Sacramento, California. “It’s going to change the way many people view the financials of these businesses and it could affect their ability to borrow.”

The issue revolves around the way real-estate leases are accounted for on official financial statements. Most businesses account for lease costs in the footnotes of the statements; they don’t appear on the actual statement that shows a profit or loss. However, the Financial Accounting Standards Board, working with the International Accounting Standards Board, has developed a plan to potentially list those lease costs clearly on the balance sheet. Once enacted as planned in 2013, all businesses would have to follow this new accounting practice.

Any lease that extends longer than a year will be put in a new category on the balance sheet called “Right to Use Asset,” which will point out the lease payments over a given period. The result, experts say, could be the end to the traditional operating lease.

“The objective is to ensure that assets and liabilities from lease contracts are clearly shown,” Shackelford says. “It’s an effort to standardize balance sheets across various companies and industries.”

The drive behind the change in what are known as Generally Accepted Accounting Principles (gaap) comes from an effort to make company finances more transparent for investors. Typically, savvy or institutional investors will see the footnoted leases and take them into account when assessing a company’s value. The complaint from banks and consumer watchdog agencies is that individual investors who may not be as adept at reading financial statements may not take the lease footnotes into account when considering a company, so when comparing two stocks, they’re evaluating apples and oranges instead of two apples.

The proposed changes have created an uproar in the financial community. Businesses with several long-term leases—those that will be most affected—have been the most vocal, and some economists say the change could hurt economic growth. Wary banks could become more conservative in their lending to companies that have reduced credit ratings as a result of the change.

The potential impact is substantial. It’s been estimated by the Financial Accounting Standards Board that more than $1.2 trillion of leased assets and liabilities will be clearly visible on U.S. company balance sheets in the next few years. “Assets will be amortized over the life of the lease, and the first few years are going to show a cost higher than the current rent payment,” Shackelford says. “As the lease continues, however, the cost drops.”

As a result of the change, quick-serve chains and franchisees looking to finance an expansion may need some extra time with their bank loan officers. “Some of the debt covenants with the bank will be temporarily out of whack, and many leases will have to be restructured into order to make the financials work,” Shackelford says. “It may create a mess for a quick serve since their store space is typically leased rather than owned.”

More than $1.2 trillion of leased assets and liabilities will be clearly visible on U.S. company balance sheets.

Although his four Midwestern Little Caesars stores are leased, Detroit-based Gary Vetter doesn’t seem too concerned about the accounting changes. “For someone like me with only a handful of stores, I don’t think about it too much,” he says.

Vetter also operates under a company that finances franchisees. “If I was a large-scale operator with lots of outlets or a corporate operator with a number of corporate-owned stores, that’s when I would be looking at how to mitigate this issue,” he says.

Looking ahead to fix what will become an unbalanced balance sheet, some owners may opt to take advantage of the listless commercial real-estate market. “I would advise clients who are considering an expansion to think about buying rather than leasing,” says Tim Anderson, a Los Angeles–based accountant who works with franchisees. “If you can get a good interest rate, you may decide to go for it, since whether it’s leased or it’s purchased, it’s going to show up on the balance sheet either way.”

Those who are considering upcoming real-estate leases may try to adjust the terms. “If these new rules take effect, I think you’ll sense a big change in long-term operating leases,” Shackelford says. “Namely, they will phase out. A long-term lease hurts your balance sheet more than the short term, although of course you’re likely to pay more for a shorter term.”

Another potential effect of the balance-sheet change will be on renewal options. If a store’s contract is a 10-year lease with an option to extend it five more years, the balance sheet must show the cost for 15 years, which will likely cause a drastic change to renewal options as they’re currently written.

Experts say the right thing to do in light of the balance-sheet changes is to make sure finance and real estate staff are up to speed in order to develop a game plan. “For some with underperforming long-term leases on their books, you may need to figure out how to restructure or terminate them, which I think is where most of the industry is headed,” Shackelford says. “Those underperforming leases are going to be clearly labeled on your balance sheet, and you will want to make sure you’ve taken care of them.”

It’s expected that there will be a transitional period as businesses and their lenders become accustomed to the new financial statements. “For companies with lots of long-term leases, their net income is going to go way down when those leases start showing up,” Anderson says. “Banks will have to be well aware of these changes and they’ll have to know that the good, profitable company they’ve always worked with is still there, except maybe not on paper.”