IFRS 16, a new accounting rule that changes the way leases are handled in financial accounting, came into force at the start of the year.
The new norms were drawn up as part of efforts from global and American accounting rulemaking bodies — the International Accounting Standards Board and the Financial Accounting Standards Board — to add transparency to financial reporting by requiring more accurate communication of long-term commitments under lease contracts.
“This standard, IFRS 16, will fundamentally change the way leases are recognized in financial statements.…The new rules will probably affect retailers more than any other sector,” according to Paul Fry, a strategic consulting partner at Cushman & Wakefield.
Under the rule, companies have to record all future lease rents as debt on the balance sheet. These financial commitments did not appear there in the past.
As for the profit and loss account, costs associated with the use of real estate assets will appear as amortization, therefore increasing the earnings before interest, tax, depreciation and amortization, or EBITDA.
Analysts expect retailers, which will see changes to their balance sheets, to be among industries most affected by the measure due to their high use of real estate leases for stores.
This will affect the way retailers handle lease renewal options as well as require them to break out charges such as utilities from rents.
Cushman estimates that globally, the bulk of around 2.6 trillion pounds, or $3.31 billion, of global lease commitments do not show up on balance sheets. In the case of a number of high-profile retail failures, the market had significantly underestimated the amount of lease commitments, noted Fry. He cited Clinton Cards, HMV and Woolworths as each having lease commitments totaling between seven and 11 times more than reported debt at the time of insolvency.
“Retailers generally have small balance sheets and enter into long-term property leases; as a result, the impacts will be disproportionately large compared with other sectors,” he added.
Carrefour last summer indicated that applying the new rule will significantly increase its total borrowings, but also result in a “substantial improvement” in recurring operating income and cash flow from operating activities.