By Paul Fry and Hannah Coleman, Strategic Consulting
In 2016 a new standard on lease accounting was published. This standard, IFRS 16, will fundamentally change the way leases are recognised in financial statements and the impacts will be share-price sensitive. The new rules will probably affect retailers more than any other sector. Industry-wide, retailers’ Balance Sheets are expected to inflate by >20% on implementation.
IFRS 16 needs to be implemented by 2019, are you prepared?
Why is this change needed?
It is estimated that there are currently £2.6tn worth of lease commitments globally. Of these £2.2tn do not currently show up on the balance sheet.
There have been a number of high profile retail failures where the extent of lease commitments entered into had been significantly underestimated by the market, ultimately proving fatal for the retailer. In the UK notable examples include Clinton Cards, HMV and Woolworths, each of which had lease commitments of between 7 and 11 times greater than reported debt of at the time of insolvency.
IFRS 16, and the equivalent US standard, seek to provide visibility of lease commitments and enable investors to easily compare the performance of comparable companies on a like-for-like basis.
Why is retail heavily impacted?
In future all leases will appear on Balance Sheet as an Asset and Liability. The P&L profile will also change; leases will be recognised in a similar way to a repayment mortgage with a high initial charge that decreases over the term of the lease.
This will impact key financial metrics including:
- debt ratios
Retailers generally have small Balance Sheets and enter into long-term property leases; as a result the impacts will be disproportionately large compared with other sectors.
Recent analysis has indicated that Tesco will see net debt increase by more than 100% from £8.6bn to £17.6bn solely as a result of the new lease accounting rules. To put this into context Tesco is estimated to lease only 40% of its real estate portfolio, so 40% of its stores, warehouses and offices will effectively double the company’s debt.
Are there specific opportunities / risks for retailers?
For retailers there are a number of areas to consider, including whether various contract types will fall inside / outside of the scope of the new standard and opportunities to mitigate the impact through specific lease terms.
Some non-lease contracts may fall within the scope of the lease accounting standard. For retailers there is a risk that certain third party logistics contract (3PLs), where a retailer outsources it logistics operations to a third party, may be treated as a lease. This will mean that the contract for logistics operations may also come on Balance Sheet.
Concessions within department stores or stands in shopping centres are unlikely to fall within the scope of the new standard. As a result, those retailers with a proportionately large number of these types of retail space will be less impacted by the new standard.
Turnover based rents will also reduce the potential impacts of the new standard and are therefore likely to become more popular. As the ‘turnover’ element of the rent is uncertain, it is ignored for the purposes of the calculations, therefore resulting in a lower Balance Sheet and P&L impact.
Data is king!
Detailed and accurate lease data is the starting point for implementing IFRS 16. Don’t underestimate the time and resources required.
The days of running a property portfolio from an Excel spreadsheet are over; retailers may therefore need to invest and upgrade their data systems. Given the volume of calculations required for a typical retail portfolio to generate the accounting entries, it is essential to put in place the right technology platform.
The key data points:
- Non-cancellable lease term
Where leases include breaks or extension options, the occupier will need to make a judgement whether they are likely to be exercised or not. Store trading performance / profitability will provide a good indication for this judgement.
- Discount rate
The applicable discount rate will need to be assessed on a lease-by-lease basis
- Rent reviews
The type of rent review mechanism will directly impact how the lease is recognised. Uncertain future increases in rent are ignored from the Balance Sheet calculations, providing a clear advantage for open market and CPI based rent reviews.
Informed decision-making can mitigate the impacts
When an occupier first adopts IFRS 16 there are various options available for recognising existing leases. Each of these options will result in a significantly different result for the Balance Sheet and P&L. Companies therefore have the ability to select the option that provides them with the best financial outcome, for retailers the focus is likely to be on mitigating impact to P&L and retaining profit margins. Ensuring that these decisions are based on robust financial analysis will be the key to obtaining the best outcome.
Change is coming! Implementation in 2019 will lead to fundamental changes to financial statements and key performance indicators. Not only this but there is a significant resource requirement to implement the standard, make sure you are prepared for the change ahead.
- Validate existing leased portfolio
- Undertake financial assessment of impacts
- Determine optimum option for transition of existing leases
- Lease data audit / data collection
- Identify preferred technology solution
- Implement IFRS 16
- Review real estate strategy
This article first appeared in the British Retail Consortium’s online magazine The Retailer
About the authors
Paul Fry is Partner in Strategic Consulting at Cushman & Wakefield.
Hannah is Associate in Strategic Consulting at Cushman & Wakefield.
About the team: Cushman & Wakefield’s Strategic Consulting experts provide innovative real estate solutions to organisations with specialised requirements. We bring together experts from finance, property and accounting to support our clients in aligning their real estate and business requirements. Visit the dedicated Cushman & Wakefield Lease Accounting page for further information.