Most UK retailers have significant property leases for flagship stores, shopping centres, other outlets and warehouses.
Owing to new accounting rules, the lease commitments will be brought on to retailers’ balance sheets. This will increase debt, EBITDA and affect other key ratios.
The International Accounting Standards Board (IASB) has decided that all lease commitments should be recognised on the balance sheet.
Their intentions were clearly noted by the IASB’s previous chairman, Sir David Tweedie, who said one day he would like to fly on an aeroplane that actually appears on the airline’s balance sheet.
International Financial Reporting Standards (IFRS) 16 Leases, containing the new rules, was issued earlier this year. From January 1, 2019, with comparative information, these operating leases that were previously ‘off balance sheet’ will need to be recognised as a ‘right-of-use’ asset alongside the future payments required on the leases.
Depreciation and interest will separately be recorded rather than as a ‘rental expense’. This will increase EBITDA and change profit profiles.
So what does this mean in real terms? The significant impact on retailers is backed up by evidence from PwC’s global survey of 3,199 publicly listed businesses across a range of industries and countries, which follow IFRS.
In this study, retailers had a median increase in debt recorded on the balance sheet of 98%.
This will affect all leases where the asset value is more than $5,000 (£3,530) and the lease is for longer than 12 months.
For retailers, the largest financial impact will be property leases but vehicles like vans, forklifts, haulage and equipment such as refrigeration units may also be affected.
“Retailers will need to carefully consider how this change in debt levels is communicated to the market and to lenders”
Kirsty Ward, PwC
While this is an accounting change and doesn’t affect the economic position or cash commitments, analysts, investors and rating agencies have tended to use rental expense multiplied seven or eight times to factor these commitments into their models.
Valuation models will need to be adapted for different measures alongside improved transparency of information about these commitments.
Retailers will need to carefully consider how this change in debt levels is communicated to the market and to lenders.
We expect that many retailers will also use this opportunity to reassess their financing arrangements and look for different terms from property owners to reduce reported debt.
For example, there may be a move towards shorter leases, higher turnover components and re-evaluation of buy versus lease decisions.
For those retailers with a large volume of leases, it will also require cataloguing and collecting all the lease data and may require the implementation of software to manage these calculations as part of the financial reporting process.
- Kirsty Ward is accounting advisory partner at PwC