Changing accounting rules and regulations can hamper the understanding of company performance, making it more difficult to assess figures, especially if investors are not fully aware of what has happened.
This is happening with the latest accounting changes relating to leases. The IFRS16 accounting standard has come into force and it will generally make debt appear higher and affect different levels of profit. This is particularly true of the retail sector.
Peel Hunt has published a note called IFRS16: Assessing the retail impact, which sets out the impact of the accounting changes on earnings and balance sheets of the retailers it covers. The broker argues that comparing different retailers’ performance from headline profit and loss will become more difficult.
IFRS16 is the new accounting standard for leases, which comes into force from 1 January this year. It is designed to make off-balance sheet operating leases visible on the balance sheet. There are balancing lease assets and lease liabilities, so there should be little effect on NAV, but debt levels will be increased. Peel Hunt estimates that the 28 retailers it covers will have an additional £14bn of balance sheet debt.
Retailers can choose whether to take a fully retrospective approach or a modified retrospective approach. The former involves restating past accounts, while the modified approach involves setting the lease liability equal to asset value at the beginning of the latest financial year. Peel Hunt has used the latter in its calculations.
The rental aspect of the lease will come out of costs, although there will be an amortisation charge relating to the lease. This means that operating profit will be higher than under the previous accounting rule.
However, there will be an additional interest charge relating the lease asset, so pre-tax profit will be less affected than it would have been under the previous rules.
Peel Hunt believes that gearing levels will initially rise sharply due to the additional lease finance on the balance sheet, but that these levels will decrease.
Onerous lease provisions are currently used when stores are not trading or can’t cover the lease charge. Under the new regulations, there would be an impairment charge that reduced the value of the lease asset in the balance sheet.
Peel Hunt estimates that operating profit of the retailers will rise by an average of 13.3%, while pre-tax profit will fall by an average of 1%.
The problem comes when comparing different retailers, some of which will have operating leases on sites, while others will have turnover-related rents, which will still be classed as an admin expense. This will make it difficult to compare operating margins.
Also, the lease is spread over a number of years, but a greater proportion of the cost will be taken in the early years. That means that the reported profit of retailers opening new stores will be held back.
The retailers least affected by the accounting changes are boohoo.com, Gear4Music, Quiz and N Brown, because they are more focused on online retail so have less in the form of fixed assets. However, ASOS does have a lease liability of £252m, due to its investment in its warehouse facilities.
The big increases in lease liabilities hit the more mature retailers, such as Marks & Spencer, Debenhams and Next. In fact, M&S accounts for one-fifth of that £14bn of additional lease assets.
Although the average difference in pre-tax profit is 1%, there are wide differences between companies. Poorly performing companies, such as Debenhams and Footasylum, will be hardest hit and they have been excluded from the calculation of the average.
TheWorks.co.uk, Gear4music, Majestic Wine and ScS Upholstery will take a hit to profit of more than 10%.
The retailers that will enjoy a profit boost of more than 10% are McColl’s, Carpetright and Moss Bros. McColl’s has leases that are coming to an end of their period, so this flatters its figure.
All the retailers will appear more expensive on the basis of enterprise value/sales, although enterprise value/EBITDA will be lower because of the removal of rents from operating costs. One of the biggest beneficiaries will be Hotel Chocolat, where the EV/EBITDA multiple will fall from 20 to 15.
It is important to be aware of these factors when assessing retail shares, because what might appear to be a better performance may be purely down to the accounting changes and not trading. Past forecasts may not take into account the IFRS16 change so they need to be treated with caution.
Once things settle down and decisions are made on how to interpret the accounting changes then they should not be a problem. It is the time when companies, analysts and investors are still coming to terms with the changes that there could be confusion.