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Accounting: Lease liabilities are real liabilities

Stephen Bouvier explores the implications for pension liabilities of the IASB’s new leasing standard 

The news that a new lease-accounting standard is on the loose will not strike many people as having much direct relevance to defined benefit (DB) accounting. But to linger too long on that thought would be to miss the point, argues Richard Farr, the managing director of London-based pensions covenant adviser Lincoln Pensions. 

“Leasing liabilities have been there for a long time. What is depressing is that we have been here before with pensions. When pensions came in from nowhere, it was ignored. Fast forward to today, and we see that most trustees are asking for more than the accounting deficit. In other words, once the market starts to understand the numbers, there is a dramatic penalty.”

So where does leasing fit in? After a decade of work, the International Accounting Standards Board (IASB) finally published its new leasing standard this January. It mainly affects lessees who, from January 2019, must employ a single, on-balance sheet leasing model. In other words, it addresses the criticism that too many lease obligations – and too much debt – is currently held off balance sheet to the detriment of investors, creditors and the cause of transparency.

The core of the new model is simple: at lease inception, a lessee must look at the payments it has committed to make, discount them back, and recognise an asset and a liability at the discounted amount of the lease payments.

“Take the example of a retailer who leases a supermarket,” says Brian O’Donovan, a KPMG partner and leasing expert. At present, the lease cost generally flows through the profit and loss on a straight-line basis over the term of the lease. But from 2019, the retailer must book a new asset and liability for each of its leased supermarkets based on the present value of the lease payments.” As a result, many retailers’ balance sheets will get bigger, much bigger. 

Moreover, from day one, O’Donovan adds, the asset and the liability reduce in different ways. “The book value of the asset decreases more quickly than the liability. Over the term of a 10-year lease, even if you pay constant cash rentals, you will report a higher total expense in the early years than in the later years of each lease. In other words, after day one, each lease becomes a net liability.”

This front-loading effect is one reason why many lessees are so upset about the new model. “Almost any financial ratio you can think of changes. If you have a lot of leased assets, then the obvious thing that happens is that your gearing goes through the roof,” explains O’Donovan.

“At the same time, because your expense categories are now interest and depreciation, your ernings before interest, taxes, depreciation and amortisation goes up. This can feel counterintuitive – it reflects the way that the cost categories are now described. And your interest cover is a lot tighter. If you are a retailer and you divide turnover by gross assets, that ratio will get a lot worse because you have all those new assets.”

The impact of the standard will be felt most among those retailers and airlines that have used operating-lease accounting to keep leasing debt off their balance sheets. But that impact will be limited for those lessees that already recognise their leases as on-balance sheet finance leases. Lessors are likely to be unaffected. 

One retailer whose name crops up in this debate is Tesco thanks to its extensive lease obligations and a major DB pension commitment. “Those lease liabilities are real liabilities,” says Farr. “If you add Tesco’s own defined-benefit scheme and its unsecured debt, you start to see that there is a lot of debt behind Tesco’s shrinking equity.”

“Once you understand that, unless you are AAA, you have a good chance of being stressed. Look at Tesco – they were once AA and now they are viewed as junk”
Richard Farr

There is, however, no automatic read-through that the new leasing standard will trigger a breach of every lending covenant across the board. “Although all these ratios change, the big question from a debt covenant perspective is whether the debt covenants are written,” says O’Donovan.

“You might have a debt covenant that excludes lease liabilities from debt, or one that is measured on a frozen-GAAP [Generally Accepted Accounting Principles] basis – that is, it is always measured on the basis of the accounting standards that were in place when the loan was drawn.”

Nonetheless, Farr sees leasing as a case of the accounting standards suddenly hitting companies that might not be in such great shape in the first place. 

“Ask yourself this: did the banks reflect IFRIC 14 in their covenant pledges? Banks are going to have to reassess their risk in terms of cashflows. Again, with the pension dynamic also being better understood, we have seen that it isn’t the accounting deficit that is the focus but what the trustees are asking for in terms of funding.

“When you add all of this together, banks will have to reassess their lending. Remember, operating-lease suppliers are creditors. They might be surprised by how much credit they have been giving to customers now they see the whole story.”

In short, he expects debt covenants to change. “The news is all one way and that is is negative. We have a perfect storm of credit downgrades. The appearance of operating leases, pension liabilities and other more enlightened creditors such as credit insurers means chief financial officers have to go through the pain barrier and explain these supposedly theoretical liabilities to their creditors – even though the fundamentals are the ‘same’ because the liabilities were always there.”

Meanwhile, it is not just accounting standards that spell trouble. Sometimes, the threat takes the form of a known unknown. In January, the Royal Bank of Scotland (RBS) announced a substantial change to its pension accounting policy, which saw it book a new charge of £1.6bn (€2.0bn).

The catalyst was the UK Financial Reporting Council (FRC). In its November 2015 Corporate Reporting Review, the watchdog declared that it expects companies to comply with something as tenuous as a set of proposed changes to the already controversial IFRIC 14 guidance on the asset ceiling.

The IASB’s interpretations committee published those changes for public comment in June 2015. Their effect is to force DB sponsors to think about how the future actions of a third party, such as a trustee body, could limit their ability to access an accounting surplus; in other words, the proposals could drive DB sponsors to recognise a new liability.

It was for this reason that the FRC’s intervention forced RBS to review its accounting policies. This is despite the fact that the interpretations committee has yet to decide how it will take the proposals forward, if at all. Nonetheless, the FRC told IPE that its approach follows the requirements of IAS 1, in that it requires entities to disclose critical judgements and areas where there are uncertainties affecting the reported numbers.

So why the apparent inability on the part of preparers to spot clouds on the horizon? In part, Farr says that the going concern assumption in accounting has blinkered the profession when it comes to assessing long-term viability.

“Everyone presumed that companies exist for ever and that big companies never go bust. The pension standards always assumed the employer would be around. But over 10–15 years, one in 10 companies will go through serious challenge. Once you understand that, unless you are AAA, you have a good chance of being stressed. Look at Tesco – they were once AA and now they are viewed as junk.”

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