Proposed changes to lease accounting will push the issue of property up the boardroom agenda, says Lucy Newman
Last week, the International Accounting Standards Board published a draft standard proposing a change in how occupiers account for leases. With property the second-largest cost for most retailers, it will significantly affect balance sheets, reported profits and property strategies.
The draft standard proposes to do away with "off-balance sheet" operating lease accounting. Instead, lessees would book an asset for the right to use the property and a liability for the obligation to make lease payments. As a guide to the scale of the potential impact, the estimated gross operating lease commitments of the top 50 FTSE companies (by market capitalisation at 30 June 2010) amount to some £100bn.
Retailers will need to consider what this will do to key performance measures such as potentially reduced return on capital and debt/equity ratios. The impact on financing strategy in respect of borrowing capacity and existing loan covenants will require careful consideration.
These proposals also affect profits. Firstly, the rental charge, currently recognised within operating profit for operating leases, will be split between amortisation and interest charge. Therefore EBITDA will increase but will be less aligned with operational cashflows.
On the other hand reported profit before tax may decrease for a retailer with newer leases or a growing lease estate, because the interest charge relating to the lease obligation would be weighted towards the early years of the lease.
It is essential that lease data is up to date and robust. The calculation of the lease liability would need to take into account the impact of rent reviews, options to renew, break clauses, guarantees and any contingent rentals. This introduces an element of judgement in terms of estimating the lease term to be used and rentals expected to be paid.
This will raise property strategy higher up the retail boardroom agenda as the historical accounting advantage of leasing disappears.
While the final standard is not expected until June 2011, the implications are too great for any retailer to delay planning for this monumental change.
Lucy Newman is a director in Deloitte's consumer business team.
Last week, the International Accounting Standards Board published a draft standard proposing a change in how occupiers account for leases. With property the second-largest cost for most retailers, it will significantly affect balance sheets, reported profits and property strategies.
The draft standard proposes to do away with "off-balance sheet" operating lease accounting. Instead, lessees would book an asset for the right to use the property and a liability for the obligation to make lease payments. As a guide to the scale of the potential impact, the estimated gross operating lease commitments of the top 50 FTSE companies (by market capitalisation at 30 June 2010) amount to some £100bn.
Retailers will need to consider what this will do to key performance measures such as potentially reduced return on capital and debt/equity ratios. The impact on financing strategy in respect of borrowing capacity and existing loan covenants will require careful consideration.
These proposals also affect profits. Firstly, the rental charge, currently recognised within operating profit for operating leases, will be split between amortisation and interest charge. Therefore EBITDA will increase but will be less aligned with operational cashflows.
On the other hand reported profit before tax may decrease for a retailer with newer leases or a growing lease estate, because the interest charge relating to the lease obligation would be weighted towards the early years of the lease.
It is essential that lease data is up to date and robust. The calculation of the lease liability would need to take into account the impact of rent reviews, options to renew, break clauses, guarantees and any contingent rentals. This introduces an element of judgement in terms of estimating the lease term to be used and rentals expected to be paid.
This will raise property strategy higher up the retail boardroom agenda as the historical accounting advantage of leasing disappears.
While the final standard is not expected until June 2011, the implications are too great for any retailer to delay planning for this monumental change.
Lucy Newman is a director in Deloitte's consumer business team.
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