Australia’s retailers predicted to be hit by lease accounting changes

Sue Mitchell, writing in the Sydney Morning Herald’s BusinessDay, (pictured) said: “Instead of recognising rent payments as costs incurred, retailers will have to expense theoretical amortisation and financing costs.

“This will boost earnings before interest, tax, depreciation and amortisation but will reduce pre-tax and net profits, as the amortisation and financing costs will exceed rental payments, especially for faster growing retailers with relatively new leases.”

Leases will also be treated as assets, but under the IASB’s draft proposal, which was released last month, leases will be amortised faster than capitalised obligations, reducing shareholder equity.

According to a report by Morgan Stanley, the impact on retailers will be “considerable”, blowing out gearing levels and reducing return on capital employed, but will vary from retailer to retailer.

Morgan Stanley says retailers with significant and long-term lease liabilities, including Myer, apparel retailer Specialty Fashion, and The Reject Shop, are likely to more affected than retailers such as Kathmandu and Fantastic Furniture.

Retailers that have grown by opening a significant number of new stores in recent years and are therefore early into lease programs – such as Lovisa and Super Retail Group – will be more affected than retailers with older leases.

“Once we get clarity on lease structures and how far they are through their lease programs we’ll be able to assess who wins and who loses,” said Morgan Stanley analyst Tom Kierath.

Retailers would have to capitalise leases of more than 12 months duration, but only up until the first “break” clause, potentially prompting more retailers to enter into rolling lease agreements rather than long-term leases.

Boost gearing ratios

KPMG audit partner Patricia Stebbens said the proposed changes would boost gearing ratios, forcing some companies to renegotiate debt covenants with bankers. “They should be having that conversation earlier,” Ms Stebbens said.

Myer, for example, has net debt around A$340 million but the net present value of its lease liabilities is estimated to be around A$2.2 billion, so its total debt would jump to A$2.5 billion. Woolworths has net debt of A$3 billion but the net present value (NPV) of its leases is around A$15 billion, so total debt would rise to A$18 billion. Wesfarmers, which owns Coles, Bunnings, Kmart, Target and Officeworks, has A$4 billion in net debt and the NPV of its lease liabilities is A$12 billion.

“Investors are aware of this [change] but not to the extent they should be,” said Mr Kierath.

Mitchell added: “The International Accounting Standards Board (IASB) first proposed bringing operating leases onto balance sheets seven years ago to give investors and creditors a clearer picture of the size of corporate debt after a spate of corporate collapses such as Enron.

“The IASB was forced into a rethink after a backlash from major retailers including Woolworths and Wesfarmers, who denounced the original proposals as complex and costly.

“The IASB completed its deliberations last month and plans to publish the new rules before the end of 2015.”

Australian Accounting Standards Board research director Angus Thompson said the new regime was likely to come into force from January 2018 at the earliest, giving corporates, their accountants and shareholders plenty of time to prepare.

“With all these things there are differing opinions and people have opposed what is happening, [but] there are other people who want to see good transparency who have generally supported it,” Thompson said. “I think it will improve the level of transparency around gearing.”

“For the average entity that has material operating leases it will gross up the balance sheet on both sides – there will be more assets and more liabilities instead of just expensing,” he said. “The impact on income will be very entity specific.”

The proposed changes may prompt retailers to disclose more details about their lease liabilities and agreements ahead of the introduction of the new standards.