New rules on how retailers account for the costs of renting their premises are likely to have a significant impact on profits and valuations, and could even force some to renegotiate debt agreements, analysts and advisers have warned.
“Historically, the expense of leases was simply recorded as an operating cost in the profit-and-loss account. Now you’ve got to bring them on to the balance sheet as assets and corresponding liabilities,” said Nick Chandler, a partner at KPMG specialising in accounting advisory services. “It’s a fundamentally different piece of accounting.”
Such is the complexity of the new IFRS 16 accounting standard, which comes into force for reporting periods beginning after January 2019, that many retailers have yet to fully disclose how they intend to apply it or quantify its impact.
The objective is to improve the comparability and accuracy of company accounts and retail is the sector where the changes will have the biggest impact; in 2016, the International Accounting Standards Board estimated that retailers had $571bn of future payment obligations that were not recorded on their balance sheets.
“We knew that sophisticated investors were taking the notes to accounts and trying to estimate obligations,” said Sue Lloyd, vice-chair of the IASB. “Less sophisticated investors simply ignored those very important obligations.”
Geoff Ruddell, an analyst at Morgan Stanley, thinks investors have not yet appreciated the potential impact on earnings. Because rent will no longer be treated as an operating cost, measures like operating profit or ebitda will rise sharply — possibly by an average of more than 50 per cent.
But the finance and depreciation charges associated with adding leases to the balance sheet will eat into net income. Mr Ruddell thinks this could lower earnings per share by 10 per cent or more, enough to move valuations in a sector where the price-to-earnings ratio is the main yardstick.
“The thing that surprises me is that no one has really given any guidance [as to the impact on profits]. You would assume they’d want to warm people up in advance of a change as big as this,” he said, noting that measures such as EPS, net debt and ebitda are often key metrics for executive pay plans and debt agreements.
There are also tax implications. Adjustments in the accounts “could result in significant differences between tax and accounting profits for the remaining terms of leases,” said Claire Hooper, a tax expert at EY. She added that for groups with lots of leases, the tax impact could be large.
Recent troubles at retailers like Homebase, Debenhams and House of Fraser have highlighted the problems of long and inflexible leases. Several companies have resorted to administration or “company voluntary arrangements” as a way of reducing their obligations to landlords.
For instance, Debenhams, a UK department store group, reports lease commitments of £4.5bn under the current rules. Under the new system, those obligations will be added to the struggling company’s balance sheet — meaning its enterprise value could rise more than fivefold.
The effort involved in calculating the correct values for hundreds or even thousands of leases is resented by finance directors. The word “onerous” came up repeatedly in their representations to the IASB during consultation.
Trevor Strain, finance director at supermarket group Wm Morrison, commented that the rules were “too complex” and recommended they be simplified. Stephen Barber, the head of the audit committee at Next, wrote in a personal capacity that they were “fundamentally flawed”.
But retailers have all had to grit their teeth and get on with it, the first decision being which reporting approach to use.
A “fully retrospective” approach involves applying IFRS 16 to every lease from its inception, then adopting the values calculated in the first accounting period that begins after January 2019. The previous year’s accounts must also be restated. This approach gives investors a base for comparison, but is more work for finance departments.
Both Tesco and Morrison are doing it this way. “It has been a mammoth effort,” said Alan Stewart, Tesco’s finance director. Mr Chandler said the investment in software to process such detail is likely to have been significant.
John Lewis and others have taken the “modified retrospective” approach, which is simpler. Leases are accounted for as if they started at the point when IFRS is adopted. No restatement of prior year’s accounts is required.
Retailers like to argue that because everyday operations — and cash flow — are largely unaffected by IFRS 16, its benefits are marginal compared to its costs.
But Mr Chandler conceded that it “did seem odd that the balance sheets of owners and renters of property could look so different,” while Mr Ruddell thinks the new standard could impact strategy too.
“Most retailers already wanted shorter leases. This gives them another reason to seek more flexibility,” he said, adding that turnover-based rents — which are much less affected by IFRS 16 — are likely to become more popular.
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