How IFRS 16 will affect retailers
As highlighted by the chairman of the IASB, the changes are expected to have a significant impact on retailers and especially those with large leasehold portfolios.
The existing position
Currently, leases are classed as one of two types - finance or operating.
A finance lease is one which is treated like a financing arrangement and the present value of lease payments is recognised on a tenant’s balance sheet as a loan liability with a corresponding asset.
Most retailers however, classify their leases using the “operating lease” model. Here, the tenant recognises the rental or lease expense as an operating expense in its profit and loss account, as it falls due. No asset or liability appears on the balance sheet and only costs such as rent and service charges are recognised in the income statement. This has the effect that operating leases are currently “off-balance sheet”.
The new rules
The accounting treatment of leases by tenants will fundamentally change when the new rules are implemented. IFRS 16 will remove the distinction between operating and finance leases, erasing the more commonly used “off-balance sheet” operating lease. Replacing this will be a single, “on-balance sheet” accounting model that is similar to the current finance lease. This will mean that nearly all leases will need to be included within a tenant’s balance sheet recognising the liability, and an asset which will reflect the right to use that asset over the term of the lease. The only leases which may be ignored are those of low value (approx. £3,500 per annum), and those with a maximum term of 12 months or less.
How will the changes affect retailers?
Although the changes will not directly impact cashflow, there will be a change to the presentation of payments and lease obligations which will now be brought "on-balance sheet". In justifying the new rules, the IASB referenced various troubled, or now defunct, retailers as evidence for the need for more transparency in relation to leasehold liabilities. Woolworths was cited as an example of a company which ran into serious difficulties despite showing little debt on its balance sheets, largely as a result of its ability to utilise the operating lease model.
In preparation for 2019, retailers will need to conduct a thorough analysis all of their leasehold portfolios, making new estimates and calculations that will need to be updated periodically in order to achieve compliance with the new standards. Finance directors are going to be kept very busy over the next few years.
To mitigate the effects of the new rules, we would expect retailers to start seeking shorter leases, more break rights, and requesting more variable lease payments to improve the shape of their balance sheets. Clearly though, this will offer little assistance in respect of existing leasehold obligations, and the new rules will be an unwelcome change for most.