Retail & consumer Retail & consumer

Proposed overhaul of accounting for leases a big

issue for the retail & consumer industry
Application date: An exposure draft was issued on 17 August 2010; a final standard is expected in
mid of 2011.

What is the issue?
The International Accounting Standards Board (IASB)
and US Financial Accounting Standards Board (FASB)
issued proposed changes to the leasing standard, which
will overhaul the current requirements in IAS 17 Leases
and reduce the differences between accounting for
leases under IFRS and US GAAP. We expect the
proposed changes to be substantial; they will have a
significant impact on financial statements.
Although a final standard is not expected until next year,
the Boards appear ready to require all leases, not just
finance leases, to appear on the balance sheet.
Why is this significant for the retail &
consumer industry?
The Boards plan to require all leases to be reported on
balance sheet. The impact on lessee financial reporting
could be substantial in the retail & consumer industry.
The impacts of this would include the following.
Entities with leases that are currently recorded as
operating leases, such as chain stores or warehouse
facilities, would be significantly impacted.
Balance sheets would grow, leverage ratios would
increase, and capital ratios would decrease.
There will be a change to both the nature of the
expense (rent replaced with depreciation/amortisation
and interest expense) and recognition pattern
(significant acceleration of total expense recognition
relative to the recognition pattern under existing rules).
Performance measures such as earnings before
interest and tax (EBIT) and earnings before interest,
tax, depreciation and amortisation (EBITDA) would
therefore change.
Lease obligations would require ongoing re-
measurement. Significant changes to internal
controls, accounting and information systems are
likely to be necessary.
Managements lease versus buy decisions may be
affected.
Management will be faced with a number of strategic
and process-related challenges associated with
implementing the proposals.
Are most retail & consumer entities
impacted?
The impact on almost all retail & consumer entities will
be significant. The changes will affect all entities that:
have lease arrangements that are within the scope of
the existing leasing standard;
are planning on entering into new leasing
arrangements; and
have operating leases which are likely to extend
beyond the transition date, which is when we expect
the new standard to be effective.
What are the overarching proposals
and the views of the retail &
consumer industry?
The key elements of the proposals and their effect on
financial statements are as follows.
There wouldnt be any scope exclusions for non-
core asset leases and short-term leases (short-
term leases are those that typically occur over 1-3
years, such as a motor vehicle lease). Retailers
have requested the Boards exclude short-term leases
from the final standard because generally they do not
result in a material impact on the income statement.
Many retailers believe that the cost and effort
involved in determining the liability and tracking the
amortisation and interest element would outweigh
any benefits to be derived from their inclusion.
Current operating lease accounting would be
eliminated. All leases, not just finance leases, will
appear on the balance sheet. Much of the criticism


September 2010 2 of 6
of the current standard relates to the fact that the
core assets of a business (eg, aircraft for airlines) are
not on the entitys balance sheet, and that the
assessment of contracts on the borderline between
operating and finance leases involves significant
amounts of time and effort and is often ignored by
analysts. Few retailers are heavily involved in
operating versus finance lease issues since their
leases are generally short-term compared to the life
of the underlying assets. It is the retail & consumer
industry, however, that will probably be the most
affected by the proposals.
A right of use concept will replace the risks and
rewards concept. Entities will recognise an asset
for the right to use the leased asset and a liability for
the corresponding cash flows at the start of a lease.
All lease liabilities will be measured with reference to
an estimate of the lease term, which may include
optional extension periods. Optional renewals would
be included at initial recognition until the exercise of
the renewal is no longer probable. Under the
proposals the right is measured at the present value
of lease payments discounted at the lessees
incremental borrowing rate. The Boards have sought
feedback on how to account for optional renewals.
The current proposal is that the most likely lease
term should be considered, requiring preparers to
make regular assessments as to whether they will
take up renewal options. This particular aspect of the
standard is crucial for retailers who in many markets
renew short-term contracts on multiple occasions.
Contingent rentals and residual value guarantees
would be estimated and included at the start of
the lease. Contingent rentals are common within the
retail & consumer industry. Few (if any) retailers
agree that contingent rentals should be included in
the calculation of the minimum lease payments.
The main reasons for this are both technical
(respondents argue that future contingent lease
payments do not meet the definition of a liability) and
also cost driven (excessive amount of work to
quantify the impact for what is effectively only a
balance sheet gross-up). If contingent rental must be
included in calculating the minimum lease payments,
there seems to be agreement amongst many in the
industry that the obligation should be measured on
the basis of the most likely rental payment.
Lessees will be required to reassess the lease
term, contingent rentals and residual value
obligations at each reporting date. Measuring the
fair value of renewal options is likely to be impractical
or the value may be negligible. The rental charges for
the renewal period are usually subject to revision
upon expiry of the fixed lease term and are not
typically specified in the lease agreements. Further,
the capitalisation of contingent rentals (eg, rentals
based on a percentage of sales) will cause a
mismatch between the sale and the corresponding
operating expense (ie, the lease payments) across
the reporting period due to seasonal fluctuations.
This will lead to significant variations of the operating
results particularly for those businesses with obvious
seasonality effects (such as retailers of air
conditioning units) for which interim results have to
be announced for public information purposes (ie,
due to local listing requirements). Determining the
value of a contingent rental is sometimes difficult in
practice. For example, certain lease payments
represent a percentage of revenue and there is an
obligation to pay only if there has been a sale. Some
entities have argued that this is a cost of goods sold
(rather than a lease commitment) with the landlord
sharing the risk of the retailers business instead of
the retailer sharing the landlords risk of the real
estate portfolio.


How would the proposals change current practice in the industry?
Key area
affected
What causes the change? Potential impact on practice
in the retail & consumer
industry
Type of entity affected
Current leasing rules Proposed leasing rules
Balance sheet
Entities apply
classification rules to
determine whether a
lease arrangement is an
operating or finance
lease. Entities only need
to recognise an asset and
a liability in a finance
lease.
A factor affecting lease
classification is whether
the lease term is shorter
or longer than the useful
life of the asset being
leased.
Entities will be required to
recognise a right-of-use
(asset) and an obligation to
pay (liability) at the start of a
lease for all lease
arrangements.
Entities with operating
leases that are likely to
continue after the new
leases standard becomes
effective will be required
to gross up their balance
sheet with additional
assets and liabilities.
Some entities key
financial metrics would
change. For example,
where metrics (such as
the debt/equity ratio) are
used in debt covenants,
the changes to entities
balance sheets may
affect their ability to
satisfy the conditions of
some of their covenants.
All entities that are lessees, in
particular those entities that
have a significant number of
operating leases.



September 2010 3 of 6
Key area
affected
What causes the change? Potential impact on practice
in the retail & consumer
industry
Type of entity affected
Current leasing rules Proposed leasing rules
Income
statement
The income charge is
calculated on a straight line
basis over the period of the
lease.
The income charge would
consist of an interest
component (which would
decline over the period of the
lease) and an amortisation
component, which would
typically be recognised on a
straight line basis.
The revised income
statement profile will result in
a significantly higher charge
in the early period of the
lease, and a lower charge
towards the end of the lease.
The differences have the
potential to be material for
longer lease terms.
All entities that have material
leases, including the most
common lease, a property
lease. It will particularly affect
entities that have longer lease
terms, such as retailers with
flagship stores that typically
have longer lease terms for
strategic reasons
Income
statement
Under existing standards,
contingent rentals are
generally recognised as
expenses in the period
incurred.

The right-of-use model would
require the initial
measurement of the
obligation to pay rentals
include contingent cash flows,
such as 'turnover rent'.
Changes in estimated
contingent cash flows would
be recognised as an
adjustment in the income
statement where changes are
based on current or prior
period events or activities. All
other changes would be
recognised as an adjustment
to the lessee's right-of-use
asset.
The proposed model could
result in a higher charge in
earlier years where entities
rental payments are based on
turnover and turnover is
expected to increase over
time. Rental expense will no
longer match turnover from
period to period.
All entities that have
contingent rent whose
turnover is expected to
significantly increase or be
volatile.
Budgeting and
remuneration
Entities typically recognise
operating lease expenses as
a component of EBITDA.
Entities would no longer
recognise any lease expense.
Instead, they would amortise
the right to use the asset over
the lease term and recognise
interest expense from
accreting the liability. These
costs are usually excluded
from the EBITDA calculation
and the interest component
would also be excluded from
EBIT.
Entities that currently have
operating leases would have
a higher EBITDA, although
net profit would remain
constant over the lease
period, but not necessarily
period by period. This may
affect entities achievement of
profit targets.
Entities that have operating
leases and that link their
compensation arrangements
to EBITDA.

Administrative
and business
processes
Entities revisit their lease
classification only if there is a
modification or extension to
the lease arrangement.
At each reporting date,
entities will be required to
reassess lease terms,
contingent rentals, residual
value guarantees, and the
corresponding liability to pay
for those rentals, if any new
facts or circumstances
indicate that there is a
material change in the
obligation.
It would mean more work for
many entities given the need
to consider individually every
lease in the portfolio, and may
require additional headcount
and new systems to monitor
all lease arrangements. The
proposed model would also
require that entities consider
time periods many years
beyond their usual planning
cycle.
All entities that are lessees, in
particular those entities that
have a significant number of
operating leases, such as
retailers.
Example. Illustrating the impact on current practice
Entity A enters into a lease agreement to obtain the right to use Equipment A for 5 years. The lease requires payments of
$1,000 on a monthly basis for the duration of the lease term (ie, $12,000 pa). There is no option to renew the lease or
purchase the equipment, and there is no residual value guarantee. The incremental borrowing rate of Entity A is 10%.
Entity A is assumed to earn revenue of $100,000 each year with an operating expense of $55,000 each year excluding
the lease expense. It is assumed that in the first year of the lease agreement, Entity A has working capital of $70,000.
Under the current lease accounting rules, Entity A must treat the agreement as an operating lease.


September 2010 4 of 6
The impact of the proposals on Entity A (the lessee) is illustrated below.
Under the new proposals - lessee to recognise lease on balance sheet
Jan-10 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Assets $ $ $ $ $ $ $ $ $ $ $
Cash 0 -12,000 -24,000 -36,000 -48,000 -60,000 Revenue
3
100,000 100,000 100,000 100,000 100,000
*ROU asset
1
45,489 36,391 27,293 18,195 9,098 0
Working capital 70,000 115,000 160,000 205,000 249,999 295,000 Amortisation
1
-9,098 -9,098 -9,098 -9,098 -9,098
Interest exp
5
-4,549 -3,804 -2,984 -2,083 -1,091
Liability
*OTP
2
-45,489 -38,038 -29,842 -20,826 -10,909 0 Total expense
4
-55,000 -55,000 -55,000 -55,000 -55,000
Profit 31,353 32,098 32,918 33,819 34,811
Net Assets 70,000 101,353 133,451 166,369 200,188 235,000
Under current IAS 17 - lessee classifies lease agreement as operating lease
Jan-10 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Assets $ $ $ $ $ $ $ $ $ $ $
Cash 0 -12,000 -24,000 -36,000 -48,000 -60,000 Revenue 100,000 100,000 100,000 100,000 100,000
*ROU asset
1
0 0 0 0 0 0
Working capital 70,000 115,000 160,000 205,000 250,000 295,000 Amortisation 0 0 0 0 0
Interest exp 0 0 0 0 0
Liability
*OTP
2
0 0 0 0 0 0 Total expense
6
-67,000 -67,000 -67,000 -67,000 -67,000
Profit 33,000 33,000 33,000 33,000 33,000
Net Assets 70,000 103,000 136,000 169,000 202,000 235,000
*ROU = Right of use; OTP = Obligation to pay
1 The ROU asset is amortised over the term of the lease on a straight-line basis. 4 Assumed annual expense (no rental expense)
2 The present value of the expected lease payments is $45,489 5 Effective interest expense allocated to each period of lease term
3 Assumed annual income 6 Annual expense including lease expense of $12,000 p.a.
Balance sheet - 31 Dec Pre-tax profit & loss
Balance sheet Pre-tax profit & loss

The impact of the proposals on financial ratios and metrics is illustrated below.
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
EBITDA (new proposals) 45,000 45,000 45,000 45,000 45,000
EBITDA (current IAS 17) 33,000 33,000 33,000 33,000 33,000
EBITDA
30,000
32,000
34,000
36,000
38,000
40,000
42,000
44,000
46,000
2010 2011 2012 2013 2014
Period
A
U
D

(
$
)
EBITDA (new proposals) EBITDA (current IAS 17)


Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Profit (new proposals) 31,353 32,098 32,918 33,819 34,811
Profit (current IAS 17) 33,000 33,000 33,000 33,000 33,000
Profit before tax profile
30,000
32,000
34,000
36,000
2010 2011 2012 2013 2014
Period
P
r
o
f
i
t

b
e
f
o
r
e

t
a
x
,

$
Profit (new proposals) Profit (current IAS 17)


Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Debt to equity (new proposals) 38% 22% 13% 5% 0%
Debt to equity (current IAS 17) 0% 0% 0% 0% 0%
Debt to equity
0%
10%
20%
30%
40%
2010 2011 2012 2013 2014
Period
P
e
r
c
e
n
t
a
g
e

(
%
)
Debt to equity (new proposals) Debt to equity (current IAS 17)


Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Return on asset (new proposals) 22% 20% 18% 16% 15%
Return on asset (current IAS 17) 32% 24% 20% 16% 14%
Return on asset
10%
15%
20%
25%
30%
35%
1 2 3 4 5
Period
P
e
r
c
e
n
t
a
g
e

(
%
)
Return on asset (new proposals) Return on asset (current IAS 17)




September 2010 5 of 6
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Asset to equity (new proposal) 138% 122% 113% 105% 100%
Asset to equity (current IAS 17) 100% 100% 100% 100% 100%
Asset to equity
95%
105%
115%
125%
135%
145%
1 2 3 4 5
Period
A
s
s
e
t

t
o

e
q
u
i
t
y
,

%
Asset to equity (new proposal) Asset to equity (current IAS 17)


Acronyms
1 EBIT: Earnings before interest and taxes
2 EBITDA: Earnings before interest, taxes, depreciation
and amortisation
3 Debt to equity ratio: Total debt divided by total equity
4 Return on asset ratio: Net profit divided by total assets
5 Asset to equity ratio: Total assets divided by total equity
The simple example above illustrates the impact the proposals could have on financial ratios and metrics. Assuming a
new lease from day 1, the measurement of EBIT will be favourably impacted due to the recognition of interest and
amortisation expense under the proposal, instead of lease expense as part of operating expenses. The profile of an
entitys profit is also likely to be affected due to the recognition of interest expense based on the effective interest method.
This replaces the straight lining of lease expense over the lease term required under the current IAS 17.
Nevertheless, the actual impact will differ for each entity depending on their profile of existing and future leases. For
example, an entity with an existing operating lease that applies the new guidance retrospectively might need to account
for the effect of having overstated lease rentals, giving a positive impact on retained earnings. Entities will need to
perform detailed calculations to understand the full impact on the metrics detailed above.
The new recognition and measurement requirements of the proposal could also impact existing bank covenants as they
may change common leverage ratios and key performance indicators (such as return on assets, debt to equity ratios, and
assets to equity ratios as illustrated above).
PricewaterhouseCoopers benchmark study
PwC has performed a benchmarking study to assess the impact of the leasing proposals on the financial statements
and key financial ratios of a sample of approximately 3,000 listed companies across a range of industries.
The study identifies the minimum impact of capitalising the operating lease commitments disclosed in the published
financial statements. In view of the proposed inclusion of contingent rentals, residual value guarantees and lease
extension options, the eventual impact may be much greater and may also impact the amounts recognised for existing
finance leases. Furthermore, the study takes no account of any transitional relief that may be available on first-time
adoption of any new standard.
Highlights from the study for retail & consumer entities include:
The average increase in retail and consumer entities interest-bearing debt would be around 64%; the average
increase in leverage (interest-bearing debt / equity) would be around 42%; and the average increase in EBITDA
would be around 34%.
The range of potential impacts is wide, but on average 24% of entities across a range of industries would
experience an increase in debt of more than 25%.
The impact differs significantly from industry to industry. Industries that will experience the most significant impact
on reported financial ratios are likely to be: retail and consumer; transport and logistics; healthcare; technology
companies; professional and other services; telecoms; real estate.
Questions for retailers to consider in the lead up to finalisation of the proposals:
Can my business accurately predict the impact the changes will have on the KPI ratios used to communicate
company performance to investors?
Should my business consider changing its operating model ie, consider more use of franchise arrangements or
reconsider lease versus buy decisions?
Does my business have the systems necessary to capture, analyse and accumulate the necessary data from a
portfolio of outlets that may run into the thousands?
Does my business need to redesign its approach to controlling capital expenditure?
How should my business prepare for any forthcoming changes to lessor accounting?
For more information on how the proposals affect retail & consumer entities visit www.pwc.com/r&c.


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