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Accounting revamp to accelerate UK retailers' push for shorter leases

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Accounting revamp to accelerate UK retailers' push for shorter leases

A new accounting standard set to come into effect Jan. 1, 2019, will shift massive lease liabilities onto the balance sheets of large retailers and hasten the U.K. retail sector's move toward shorter and more flexible leases, according to senior industry figures from the financial, retail and real estate industries.

International Financial Reporting Standard 16 requires companies to report leases on their balance sheets, in contrast to the current standards, under which operating leases appear on companies' profit and loss statements. Leases will appear on balance sheets as assets for the right to use the leased item and as liabilities for the present value of the company's future lease payments.

The change will particularly affect companies whose operations require them to lease large amounts of space, and retail is among the most affected industries given the number of leases retailers will have on their books, Rebecca Farmer, a partner and lead for accounting change at Ernst & Young, said in an interview. It will be especially punitive to retailers that have very long leases due to the size of lease liabilities coming onto their balance sheets, said Chris Spearing, a London-based director and real estate equity analyst at investment bank Canaccord Genuity.

"We know who they are: the Debenhams and others of this world," he added, referring to the U.K.'s largest department store tenant by operating lease obligations.

Driving up debt

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Depending on the calculation that accountants use when transferring operating leases from a company's P&L statement to a liability on its balance sheet, a company's debt could appear to be much greater than it does under the current process. Retailers that report under IFRS are expected to see a median increase in debt of 98%, the largest of any industry, according to a 2016 PricewaterhouseCoopers LLP study, published shortly after IFRS 16 was announced. The introduction of the standard comes as many traditional brick-and-mortar retailers in the U.K. are losing sales to e-commerce and struggling with intense competition in an unfavorable economic climate.

The level of debt that will appear on a company's balance sheet following the implementation of IFRS 16 will largely depend on how accountants calculate the net present value of future lease payments when transitioning leases onto the balance sheet, said Farmer. IFRS 16 allows accountants to use two different options for calculating: One that uses a company's historical leases to determine a discount rate that is then applied to the value of future leases to calculate their net present value, or another forward-looking method that is based on borrowing rates at the date of transition.

Since borrowing rates are low, this would lead to a very low discount rate, said Farmer, which would result in a company's lease liabilities appearing to be relatively much higher. "A small movement in the discount rate can have a very large impact on the liability," Farmer said. "The way that people apply the standard will make a lot of difference to the liability that comes on the balance sheet."

Evolving lease structures

The liability appearing on a company's balance sheet under IFRS 16 will be based on the noncancellable period of a lease, and companies are looking at ways they can structure their leases to make that noncancellable period as short as possible, said Farmer, including such options as adding a termination clause or break dates at one or more periods.

Leases with break dates give the retailer the option of canceling a lease after an agreed number of years, and retailers are only required to record the lease liability until the break date if they do not extend the lease beyond that. Revenue-based leases, which involve the full or partial payment of rent based on the income generated by the retailer in a store, would also allow retailers to reduce their lease liabilities.

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Such lease structures have become increasingly common in the U.K. retail sector as difficult operating conditions have pushed retailers to seek more flexible terms from their landlords, Canaccord's Spearing said. Some retail landlords in the U.K., particularly those active asset managers with prime shopping centers, like Hammerson PLC and Intu Properties PLC, increasingly prefer shorter leases as these leases allow owners to refresh their retail mix regularly and move on underperforming retailers quickly.

Other more passive retail landlords are less likely to welcome shorter and more flexible leases, said Spearing. "A lot of the institutional owners of retail real estate are going to be less active in terms of their management, so they will probably prefer to have longer leases in place," he said. "It's those shopping centers in the more marginal locations that are at risk, where a retailer would have signed a lease 10 to 15 years ago and it will be coming up for expiry."

In 2018 so far, several high-profile U.K. retailers have announced store closures or warned of trouble to come. The latest victim is Mothercare PLC, which announced on May 17 plans to close 50 stores across the U.K.

The U.K. retail sector will continue to face challenging operating conditions, said Richard Hyman, an independent retail analyst who advises some of the U.K.'s largest retailers. "We're in the foothills," he said. "This is the very beginning and it's going to last years. What we're seeing is a fundamental restructuring [of the sector]. That's why we're seeing all this distress."