Playing by the (new) rules | Fin24

Playing by the (new) rules

Oct 08 2019 08:38
Simon Brown

Pick n Pay recently came out with details of how IFRS 16 will impact its numbers. This got the market talking. 

The bottom line is that Pick n Pay’s ‘debt’ levels jump from under R2bn to a staggering R17bn.

And no, the company has not taken out a giant loan. It is merely a result of new accounting rules. But first, what is IFRS?

The International Financial Reporting Standards are used as accounting standards globally, the exception being the US; they use generally accepted accounting principles (GAAP).

While different, they both serve the same purpose: a standardised way of accounting that means we can compare apples with apples.

The IFRS standards are continuously evolving as new business models, fraud and regulations arise. As such, companies using IFRS will update their uses of the standards. IFRS 16 was implemented at the beginning of 2019 and, for companies like Pick n Pay that are now using it, the major issue is how a lease is reported.

In short, the entire value of the lease needs to be added to the balance sheet as both an asset and a liability. On a net basis, it has no impact as it equals out on both sides of the equation.

But, truthfully, it is not as simple as that.Let’s look at the example of Pick n Pay. They have a large number of leases for their stores, and I would imagine that most of these leases are long-term in nature. Nothing new here; they have always had leases and always will. 

But now, under IFRS 16, they have to move these onto the balance sheet as a debt obligation.I have no issue with this idea. Let’s say you rent a flat for R2 500 a month. A one-year lease for that flat is an obligation to pay R2 500 a month for 12 months.

In total, that is an obligation of R30 000 – although, of course, we view it as 12 single monthly obligations of R2 500. Every month your salary comes in and covers the rental, no problem. 

But what happens if in month five you lose your job? You still have seven months of R2 500 monthly rental obligations to pay, but now you have no money coming in to pay it. So, a lender, for example, would want to know about this rental obligation before they’d lend you money, as it certainly adds risk if you lose your salary.

The same is true for a retailer such as Pick n Pay. If they never sold another item, they’d still have to pay more than R15bn in leases – but without receiving any revenue.

The actual nuances of the process are extremely complicated, with interest being front-loaded – which will have a larger impact in the first years of a lease and less impact on the last years of a long-term lease.

While Pick n Pay is the first company to experience a really large IFRS 16 impact, we should certainly expect a lot more companies to be reporting similar issues. All retailers (food and clothing) with large store footprints will be hit. Spar is the exception, as it operates on a franchise model.

This means leases are at owner level, not group level. But banks will, for example, also have to take this on board. Even Clover leases its delivery fleet and will have to account for this accordingly.

Overall, I agree with the logic and it won’t impact the operational part of the business at all. But it is going to make results even more complicated (aside from the initial hit like we’ve seen at Pick n Pay).

Hopefully, companies will provide solid details in their results, explaining what impact – positive or negative – the new rules are having.

This article originally appeared in the 10 October edition of finweek magazine. Buy and download the magazine here or subscribe to our newsletter here.  

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