Retail Companies and Lease Accounting

Retail companies have traditionally been one of the largest users of real estate in the world.

It is common for retail companies to lease out large commercial retail spaces and utilize them in their business.

Over the years, the usage of real estate has drastically come down because of the increase in online retailing. However, retailers still continue to be amongst the biggest retailers of commercial spaces across the globe.

For a long period of time, the accounting standards across the world were not equipped to manage the complexities present in leasing contracts. However, with the passage of time, accounting standards have become more stringent. In this article, we will try to understand how the new lease accounting standards have an impact on the business of retail companies.

What is New in Lease Accounting?

Leases were considered to be a source of off-balance sheet financing in the past. It was common for retail companies to enter into multiple lease agreements which drastically increased their liabilities. However, since accounting standards did not require the retail companies to recognize such liabilities, the liabilities went underreported to a large extent. However, that has changed with the change in accounting standards across the world.

Accounting standards now require retail companies to recognize lease liabilities on their balance sheets. In order to balance these liabilities, they are also required to recognize a right of use asset on their balance sheet.

It needs to be understood that the right of use asset is actually different as compared to the actual asset in consideration. The detailed rules related to lease accounting have been provided by various accounting standards including the International Financial Reporting Standards (IFRS).

What Constitutes a Lease?

Since the rules related to lease accounting have been clearly defined, it is also important to understand what constitutes a lease in the first place.

Almost all accounting standards have different criteria when it comes to accounting for a lease. However, there are two important points which need to be considered while considering whether a given transaction is a lease or not.

1. Identifiable Asset: The first criteria for identifying a lease is that the asset must be identifiable. For instance, the commercial space being handed over to the retail company must be clearly demarcated and identifiable. If the asset whose possession is being handed over is not easily identifiable, then the transaction may not qualify as a lease.

   Let us take an example wherein a car is leased to a retail company. In this case, if the car can be interchanged during the period of the contract, then it cannot be considered to be a lease contract.

2. Control Over Asset: In order for any transaction to be called a lease, it is important for the possession of the asset to be exclusive controlled by the lessee.

   For instance, decisions relating to revenue generation by the use of the asset must be independently taken by the lessee. If the lessor has significant control over the lawful use of an asset, then such a transaction cannot be considered to be a lease.

How Indirect Lease Costs are Accounted for?

Whenever a lease transaction takes place, there are a lot of indirect costs which accompany these transactions. For example, there might be legal fees, commercial agent fees, fitout fees etc which may have to be incurred as and when the lease contract is executed.

In such cases, some of the transactions which are incurred may have to be capitalized along with the lease and then amortized at a suitable time. On the other hand, there are some expenses which may have to be expensed during the same period.

Accounting rules state that if an expense can be directly and explicitly associated with a specific lease, only then it can be capitalized.

For instance, if a fee was paid to a commercial agent to find a property and this fee was not paid for a specific property but in general, then such expenses cannot be capitalized as per the new lease accounting rules.

Separation of Lease and Non-Lease Components

It is important to realize that a lease may contain certain expenses which may not be directly related to the lease. For instance, expenses related to the upkeep of common areas should not be considered to be included in the lease.

Accounting standards have identified the existence of such expenses and have created rules regarding how they should be accounted for. Non lease expenses should not be capitalized. Instead, they should be accrued and expenses as and when they become due. The separation of lease and non-lease components of a contract may be a complex activity since there are many rules which determine precisely which expense can be considered to be part of a lease and which expense cannot be considered.

Variable Leases

Last but not the least, it is possible that the lease amount may not be fixed. Instead, there may be a minimum threshold lease amount which may have to be paid and the balance amount may depend upon a variable such as the quantum of sales achieved. The accounting for such variable leases is a complex subject which will be explained in detail in a different article.

For now, it is important to understand that the accounting treatment of leases has a huge impact on the financial performance of any retail company. As a result, retail companies need to be well versed with these leasing rules and need to develop their financing strategies accordingly.

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