Caroline Biebuyck 27 Jul 2017 10:00am

Why IFRS 16 will radically change the retail sector

The retail sector is shaping up for some radical changes with the introduction of the leasing standard, as Caroline Biebuyck finds out

Caption: The premise of IFRS 16 is simple: to bring all companies’ leases onto their balance sheets for 2019 accounting periods onwards.

Introducing new accounting standards is never easy. But the challenge retailers face with the incoming international leasing standard is turning out to be particularly tough. Not only is implementation proving a major administrative headache – the new rules could bring the biggest shake-up to retailers’ financial statements for decades.

The premise of IFRS 16 is simple: to bring all companies’ leases onto their balance sheets for 2019 accounting periods onwards. Consider what this will do to the balance sheet. Assets will rise substantially – but so will liabilities: early estimates suggest that average debt will increase by 100%. This could spell bad news for borrowers if the rise in gearing causes a problem for debt covenants. And that’s before considering any knock-on effect on the cost of borrowing.

Over in the profit and loss account, the current operating lease expense will be replaced by depreciation of the lease asset and an interest expense on the lease liability. While the depreciation charge will be straight-line, the finance charge will be higher in the earlier years of the lease than the later ones.

The impact could be somewhat counter-intuitive, says Lucy Newman, IFRS 16 audit partner at Deloitte. “Some better-performing retailers, companies that are expanding and leasing new premises, will effectively be penalised for taking on new leases while less well-performing companies might seem to be in a better position,” she says.

Companies will be reporting higher operating profits than in the past as the interest cost will drop below the line. EBITDA will look better as it will exclude both interest and depreciation (currently it includes the operating lease expense): estimates are that EBITDA could rise by more than 40% for many retailers.

The challenge is for companies to explain what these changes will mean. Good communication is paramount in getting the message across to different stakeholders about how implementing the new standard is going to affect reported performance and financial position.

The recent ICAEW report Audit insights: Retail – are you ready for a radical change? outlines the different audiences that companies will need to communicate with, those audiences’ challenges, and the issues they will need to address or understand.

Externally, companies need to explain the changes to analysts, shareholders and other account users. No longer will these parties be able to use the current broad-brush approach of assigning an estimated eight times annual rental to factor debt into their valuations of lessee companies. The new debt profile under IFRS 16 will be specific to each company, its lease profile and the ages of those leases – and retailers will need to give analysts, rating agencies and shareholder groups an idea of what they should expect this to be.

This is on the radar for the sector that Julie Carlyle, chair of the ICAEW report’s working group and head of retail at EY, speaks to. “You cannot over emphasise how critical it is for people to get to grips with this,” she says. “Conversations with analysts, shareholders and banks are happening: some of these external parties are further ahead with their thinking than others. But I would like to see these conversations being more advanced.”

Companies need to make sure that their management and boards know what the changes will mean. This involves looking at the challenges and impacts across the company, not just the finance team.

This is why the British Retail Consortium has been advising retailers to assemble cross-functional project teams to work on the new standard. These teams should include colleagues from property, finance, accounting and tax to conduct a high-level assessment, implementation and communication plan, believes Jim Hubbard, policy adviser for local engagement, property and planning at the BRC.

“We have been able to help inform property teams and encourage them to go to their colleagues in finance and tax to ensure they could ask the appropriate questions and start planning,” he says.

Implementation is proving tough. Retailers don’t just lease property, they lease many assets used within their stores and other premises. “It would not be unusual for a typical large retailer to have between 5,000 and 10,000 leases,” says Carlyle.

This explains why the biggest headache for retailers is data. These companies, which have not really had to worry about having robust and complete operating lease data in the past, now have to collect an estimated minimum of 25 to 80 data points for each lease, with some of the information relating to contracts dating back 30 years. This is leaving companies struggling to collect all the information on rent payments and rent increases over often lengthy lease periods – especially when those periods pre-date their electronic records.

Counting the cost

Companies tend to be good at keeping records of items that are on the balance sheet, says Eddy James, ICAEW technical manager: it’s those that were previously off-balance sheet that are the problem. “If you are looking at large and diverse businesses operating in different countries, tracking down what could be many thousands of leases in different languages, different locations and different legal regimes is a massive task. How are companies going to tackle all those filing cabinets, archive files and computers to find those lease agreements to fully understand all the terms and conditions?”
Technology can help. Carlyle thinks some companies will use AI and robotics to monitor and analyse that data. “If companies can pull historic data into some sort of digital format then analytics tools can scan the digital leases and perform the calculations needed. There are already moves down that route.”

Once the data is in place retailers need to work through the options in the standard. Leases worth less than $5,000 (£3,860) can be kept off the balance sheet, with a decision on what to do with them made on a lease-by-lease basis. Leases for less than 12 months can also be expensed, again on a case-by-case
basis. Meanwhile, companies need to consider different transitioning choices and how to deal with issues such as variable lease payments, options to extend the lease, and early termination clauses.

The complexities in the standard, with the various choices and exemptions, all need to be modelled to ensure that the company makes the right choices in time for implementation. “How you make these decisions will have a massive impact, not only in the year of adoption but for many years to come,” according to James.
“This will involve a lot of detailed financial modelling, looking at all the various options and projecting them forward.”

One of the big selling points of IFRS 16 was that it would bring comparability across sectors. The reality is not so simple. An obvious problem is that many UK retailers are not listed, meaning they will continue to comply with the operating-or-finance-lease rules in UK GAAP rather than IFRS 16.

Then there are the options around transition and the choices available for certain types of lease. Carlyle says this means there won’t be true comparability between retailers for some significant time. “Realistically this will only be when all the current leases unwind, probably about 20 years from now,” she says. “The question is: what will external stakeholders be looking at to try to compare these businesses? That has to change. There might be a focus on cash generation instead. But the whole issue is something that is currently being discussed.”

Comparability is also an issue for internal reporting. “How do you compare performance between a new store and an old one, given this will be skewed by where they are in their lease terms?” asks Newman. “Do you strip out the IFRS 16 charge and go back to a cash basis? This is a big question given the low margin, high-pressure retail environment, where assessing the real contribution of the physical store estate is becoming increasingly critical.”

Hubbard says retailers need to determine what they want to achieve early on, answering strategic questions about the impact on the income statement, discount rate and transition. “These discussions should involve colleagues from across the relevant teams and help the company form a long-term strategy.”

This is becoming more important than ever. Store strategy is now one of the most fundamental pieces of a retailer’s jigsaw, with property portfolio flexibility crucial for commercial success. “Shorter leases are more feasible and attractive for many reasons: the changing nature of retail, the omni-channel transformation and the slightly more competitive property market than in the past,” says Hubbard.

Of all the questions that Newman gets asked about implementation, the most common are to do with systems. Most large retailers acknowledge that lease records cannot easily be kept on spreadsheets, as there is simply too much data, she says. “Companies will need to update the data for each lease on an ongoing basis, for instance reflecting every rent review or change in lease terms. Many retailers already have some kind of lease management system so their question is, how do they upgrade this or get an effective calculation engine to deal with IFRS 16 requirements that will feed through to their main finance system?”

Customer experience

Another question is, where do they find the resources in this difficult economic environment? Retailers are under unremitting sales pressure, with companies responding by investing in technology aimed at improving customer experience rather than helping with their administration. And additional costs from rising business rates, implementation of the national living wage and the apprenticeship levy are squeezing margins even tighter.

Companies need to balance investment between the things that drive successful growth and those that help contain costs, says Carlyle. “Making a business case for this investment is difficult, but I don’t think there is an option. If this process stays manual, you would need a significant headcount and would run a high risk of getting it wrong. Companies want to make the process as lean as possible, looking across the rest of their finance function to use the cleverest technology to achieve that.”

Having the correct information combined with more visible leases in the business and on the balance sheet should help drive better business decisions, says James. “People signing leases in the future will know what the accounting implications are for clauses and terms and conditions. With the right training and support, they can see the kind of results that different leases will give. Retailers will still want to sign the lease that makes the most commercial sense. But the company will benefit if the lease also fits the accounting picture.”

ICAEW and the IFRS Foundation will hold a virtual conference on how to implement IFRS 16 in practice on 10 October. Details can be found at icaew.com