Lease Accounting Comment Letter

July 17, 2009

Technical Director
Financial Accounting Standards Board
401 Merritt 7
Norwalk, Connecticut  06856

International Accounting Standards Board
First Floor
30 Cannon Street
London, EC4M 6XH
United Kingdom

RE:  File Reference No. 1680-100

Dear Members of the FASB and IASB:

The National Retail Federation (NRF) welcomes the opportunity to comment on the Financial Accounting Standards Board’s (FASB) Discussion Paper on Leases (DP).  NRF is the world's largest retail trade association, with membership that comprises all retail formats and channels of distribution including department, specialty, discount, catalog, Internet, independent stores, chain restaurants, drug stores and grocery stores as well as the industry's key trading partners of retail goods and services. NRF represents an industry with more than 1.6 million U.S. retail establishments, more than 24 million employees - about one in five American workers - and 2008 sales of $4.6 trillion. 

NRF supports the FASB’s decision to address lease accounting and recognizes that the Boards are committed to a model whereby lease obligations will be recorded on a company’s balance sheet.  However, there are several areas in the new lease accounting model that add unnecessary complexity, create a lack of comparability with regards to the income statement, and impose significant administrative burden.  The complexity of the proposed leasing standard has retailers worried about its practicality and the cost to implement.  We ask the Boards to give serious consideration to the concerns we’re raising. 

By its very nature, the retail industry manages a substantial number of leases.  Many of our members have hundreds, if not thousands, of stores, each with its own unique lease agreement, facts, and circumstances.  As the DP currently outlines, all of these leases will need to be recorded on the books, with estimates made for the lease term and payment obligation, and capitalized at the incremental borrowing rate with perhaps continual adjustment to the estimates.  Meeting these requirements and making adjustments and reassessments, in particular, would be a huge burden on retail companies.  The industry is concerned that the costs of implementing the new lease accounting model – when some would argue that a lease is different from actually owning the leased facility – outweigh the benefits.

When the final standard is released, it is essential that investors and analysts are educated on the changes and their impact on comparability.  For example, the DP will significantly alter the appearance of financial statements, including the ballooning of assets and liabilities on the balance sheet.  Long-term debt will increase and the geography of the P&L will change.  G&A will decrease, while interest and depreciation will increase.  In addition, debt covenants will be under pressure and potentially breached.   

Addressed below are questions from the DP that are of particular concern to retailers. 

Short-term Leases
Question 2
Should the proposed new standard exclude non-core asset leases or short-term leases?  Please explain why.

Short-term leases (i.e. less than 3 years) should be excluded from this guidance, particularly if they would have an immaterial impact (individually or in the aggregate) on the financial statements.  Retailers frequently enter into a short-term lease to test a new market or complete renovations.  Due to the complexity of the proposed standard and the time required to comply, short-term leases should be excluded when they are less than three years in length, not a significant source of financing for the company, and immaterial to financial statements.  Non-core asset leases should not be excluded from the new standard.

Initial Measurement
Question 6
Do you agree with the boards’ tentative decision to measure the lessee’s obligation to pay rentals at the present value of the lease payments discounted using the lessee’s incremental borrowing rate?

If you disagree, please explain why and describe how you would initially measure the lessee’s obligation to pay rentals.

The incremental borrowing rate is indicative of a company’s risk profile and is a good proxy for lease capitalization rates.  However, using this rate will result in inconsistent presentation between companies for depreciation and interest expense due to the variation in each company’s incremental borrowing rate, with differences in rates impacting the level of depreciation and interest expense to be recognized. 

A company with a good credit rating and therefore a lower incremental borrowing rate will record a larger asset (higher depreciation) and lower interest expense compared to a company with a lower credit rating that will record a lower asset (lower depreciation) and higher interest expense.

Using a rate such as the risk free t-bill/t-note rate for the time period consistent with the lease term would enable a more comparative result between companies.  There should also be an option to use the rate implicit in the lease if it is known, though in most cases this is difficult to ascertain.

Lease Term
Question 13
The boards tentatively decided that the lessee should recognize an obligation to pay rentals for a specified lease term, ie in a 10-year lease with an option to extend for five years, the lessee must decide whether its liability is an obligation to pay 10 or 15 years of rentals.  The boards tentatively decided that the lease term should be the most likely lease term.

Do you support the proposed approach?

Many retailers sign leases with initial terms of 5-10 years followed by the option to renew.  At the inception of the lease, it can be difficult to predict if the lease will be renewed after the initial term ends.  Market variables, including the real estate market, local economy, and population shift, will often determine whether or not a lease is renewed.  Options should be included in the lease term once a company has determined that it is reasonably likely that they will be exercised.  

Contingent Rent
Question 16
The boards propose that the lessee’s obligation to pay rentals should include amounts payable under contingent rental arrangements.

Do you support the proposed approach?

In the retail industry, the most common type of contingent rent is based on percentage sales.  These leases are typically structured so that additional rent is owed on top of the base rent when sales exceed a certain volume.  In some cases, contingent rent makes up a larger portion of the total rent paid, perhaps even all rent paid, depending on the circumstances. 

When the amount of contingent rent is immaterial – as is often the case when contingent rent is added only above a certain level of sales – the incremental contingent rent portion should be excluded from the obligation.  Due to rapid and unexpected changes in the retail landscape and economic environment, it would be extremely complex to forecast sales and arrive at the proper estimate for contingent rent, particularly when the amount is immaterial.

When the amount of contingent rent is material and leases are structured so that a large percent of the rental obligation is based on a contingency, an estimate should be made based on the best possible forecast of sales and included in the obligation.

The boards discussed two possible approaches to recognizing all changes in the lessee’s obligation to pay rentals arising from changes in estimated contingent rental payments:

(a) recognize any change in the liability in profit or loss
(b) recognize any change in the liability as an adjustment to the carrying amount of the right-of-use asset.

Changes in estimated contingent rental payments, such as percentage rent, should be an adjustment to the leased asset and not to expense.  Any change to the estimated rent and the actual contingent rent should be considered a change to the value of the right of use asset.  Due to the complexity of forecasting sales and estimating the rental obligation, retailers are concerned that they will find themselves resetting the obligation quarterly, if not more frequently; thereby creating volatility in the P&L.  These frequent changes have the potential to be very confusing for the users of financial statements.

Other Issues
Question 24
Are there any lease issues not described in this discussion paper that should be addressed in this project?  Please describe those issues.

Executory Costs
Executory costs are charges that may or may not be embedded in lease agreements.  Examples include common area maintenance, real estate taxes, and insurance.  When these charges are broken out separately in a lease (net lease), only the contractual rent should be included in the obligation.  The executory costs should be recognized consistent with current practice as period costs.  Recognizing non-contractual rent obligations such as CAM and real estate tax would result in inconsistent treatment of such costs between owned properties (period costs reported as SG&A) and leased properties (capitalized with right to use asset and obligation and then amortized as depreciation and interest expense). 

However, in the case of a gross lease, when executory costs are embedded in the lump sum contractual rent payment, the costs should be included in the obligation.  Breaking the charges out of the gross lease would be a significant burden for retailers, particularly given their immateriality.  In addition, because the charges are part of the contractual rental payment, they fit the definition of a liability and should be included in the obligation.

Amortization
FASB should address and clarify when amortization begins for the asset and obligation (i.e. possession of asset, signing of lease agreement).  We strongly recommend consistency with current guidance regarding holiday rent, which assumes that the lessee takes possession of the property at the inception of the lease.

Lessor Accounting
Question 26
This chapter describes two possible approaches to lessor accounting under a right-of-use model:  (a) derecognition of the leased item by the lessor  or  (b) recognition of a performance obligation by the lessor.

Which of these two approaches do you support?  Please explain your reasons.

Lessor accounting should mirror the accounting for the lessee.  The lessor should record a liability and reduce the asset on their books.  In the lessor’s case, the obligation is providing the lessee the right to use the asset.  A receivable should then be added for rent.

NRF thanks the FASB and IASB for their consideration of our comments and suggestions and welcomes any further discussion on the topic. 

Sincerely,

Carleen C. Kohut
SVP and Chief Financial Officer