UK retailers may deliver a shock to unwary investors when their next full-year balance sheets are reported. The reason has to do with a new accounting standard — don’t switch off just yet — that will have to be adopted for any accounting periods that began later than 1 January 2019.
IFRS 16, the new standard, changes how lease commitments are recognised. Previously, with an operating lease on, say, a building, payments were recorded on the income statement as an operating expense, and aside from reporting the next five years of lease expenses in the notes to the financial statement, that was it. With a capital lease, an asset is brought onto the balance sheet, and all future lease payments are recorded as liabilities, with a depreciation charge and an interest expense appearing on the income statement.
Retailers will not eventually own the buildings they lease, therefore they can typically classify such a lease as operating, and reduce reported financial leverage by not recognising a liability. However, the new standard mandates that nearly all operating leases will be reported like capital ones, and the lease commitment will be recognised as the debt it really is.
Although other firms have taken the opportunity to begin incorporating the standard early, retailers have not been keen. This is not surprising, as according to a global lease capitalisation study conducted by PricewaterhouseCoopers, an international accounting firm, retailers stand to see a median increase in their debt of 98%.
According to guidance issued by Halfords, its 2020 annual report will show a new £450m operating lease liability on the balance sheet. Marks & Spencer estimates its liability to be around £2.6b, and Next forecasts £1.4b. These are huge values, and although there will be a recognition of balancing assets of £400m, £1.7b and £1b, respectively, these three UK retailers will report very different financial positions in next year’s annual reports.
Investment analysts have routinely brought operating lease liabilities onto their adjusted balance sheets when they value companies. However, investors used to using databases that report unadjusted full-year numbers will see dramatic changes when new, full-year results are added, as lease liabilities move from off-balance-sheet to on.
Income statements will also be affected as operating income will increase as lease payments are replaced in part with a smaller depreciation charge. Net income may rise or fall depending on whether the sum of the depreciation charge and imputed interest payment is less or greater than the lease payment.
The net effects will include reducing return on capital, variable changes in return on equity, increasing debt ratios, and generally worse interest coverage. As a result, stocks that would have once been screened-in may be screened-out, or they may be sold outright if held.
Next released a half-year report on 19 September 2019 that was subject to IFRS 16, and its share price dropped 5.7% in a day. It has since recovered, and more than just concerns over debt may have been behind the drop, but I would expect something similar on publication of both Halfords’ and Marks and Spencer’s half-year results.
The share price effect could be much greater when full-year numbers are released by these three and others, as they attract more attention.
James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.