Top issues for retailers

Transcript

Shreeya: Hello, and welcome to the first podcast in our series “The Top-Shelf” which deals with topical issues in IFRS that impacts clients that operate in the Retail & Consumer Industry.

My name is Shreeya and I work at PwC’s Accounting Consulting Services. I am joined today by Ronel Fourie, who is a director at PwC and is also our Accounting Consulting Services Retail Industry Leader.

Ronel: Thank you. Good to be here in the isle looking for what is interesting on the top shelf.

Shreeya: Ronel,a lot has happened in the past year in the world of retail.

We had COVID, lockdown … and IFRS 16 (the new leases standard) all in one reporting period!

We pulled a sample of a few retailers listed on the JSE and their average reporting date was delayed by 39 days compared to prior years. Out of everything that has happened, what were the biggest issues for retailers this year in your view?

Ronel: There were several salient issues that retailers experienced during 2020 which carried through into this year.

We have experienced transition to a material new standard, IFRS 16 leases and retailers felt pressure from a working capital management perspective due to a strained economy. The focus on working capital management naturally attracts thoughts about debt covenants as well as debtor book management…. All against the backdrop of a disrupted work environment!

Out of everything that’s happened, from an accounting and commercial perspective, there has been a significant shift in the balance sheets of retailer-lessees as a result of accounting for right of use assets and lease liabilities under IFRS 16.

The quantum of right of use assets in many South African listed retailers reached into the billions.

Shreeya: I agree,and there were numerous complexities around transitioning to the new Leases standard - such as weighing up the different transition methods. Although - I am glad that transition to IFRS 16 is now a thing of the past!

Ronel: Certainly, I think the biggest hurdles of transition are definitely behind us now… However, now we are looking to the future and many retailers realised that they need to refine or enhance their accounting systems to be able to deal with the added complexity of accounting for leases under the new standard.

The contemporary IFRS 16 issues are items such as lease modifications, rent concessions and taking care of the existing lease portfolio from a subsequent measurement perspective, including reassessing lease terms and the likelihood of exercising renewal options

Furthermore, it’s an observable trend in retail to note that some companies could not take advantage of the IFRS 16 lease concession amendment because their accounting systems were not configured to support it! Those companies elected to not apply the practical expedient.

As a heads-up, the IASB had an exposure draft out for comment that proposes an extension of the date the rent concession expedient can be applied. They will probably extend the date to June 2022.

Shreeya: Ronel I think you’ve touched on a number of great points there - particularly, I find it really interesting that - if our accounting systems aren’t equipped to deal with the IFRS 16 accounting complexities - how are we, mere humans, expected to go along with it!

That being said Ronel - what are the top tips you have for retailers out there looking to make some changes to their existing leases? For example - what do we need to think about if we are downsizing our leased spaces; let’s say a specific retailer wants to reduce their store space in a physical capacity.

Ronel: So if you’re downsizing your leased space, you need to look to IFRS 16’s modification guidance. Also- hopefully - you’re going to be paying less for the store as well, because you’ll have less space.

A way to think about the accounting for that element is to think about an ‘in-substance’ disposal’ that will happen in two steps.

Firstly - let’s say you’ve reduced your leased space by 30% - you need to proportionally reduce the asset and the liability by 30% as well. However, because your lease liability and right of use asset are not at the same value - you’re going to end up with a balancing profit/loss impact.

Shreeya: Okay, step one of accounting for a lease modification is proportionally reducing the lease asset and liability, which can result in a profit/loss impact. We’ve actually seen some retailers disclose that value on the face of their income statement - gains on lease modifications, particularly.

What is step 2 of accounting for a modification like this?

Ronel: Step 2 is to remeasure the value of your lease liability. You need to ensure that the lease liability reflects the economic realty at the date at which you have modified the lease. So you’ll need to remeasure the lease balance using an updated incremental borrowing rate and updated lease payments over the remaining lease term.

Shreeya: Okay, Step 2 is just capturing those updated economic variables and effectively ‘truing up’ the remaining lease liability! Got it! Thanks for explaining to us, Ronel.

Speaking of ‘economic realities’ Ronel, what else do you think is pressing in the commercial retail world ?

Ronel: Another big issue last year were changes to financing models. Retailers had to have a careful think about their debt funding, given constrained consumer spending and revised macro economic projections in many territories. We saw a number of renegotiations of debt or debt-covenants with banks.

I anticipate that, given the pressure the economy is under, retailers will have to continue to ensure they’re managing their debt - and capital structure more broadly - in an effective manner. In other words, this issue could remain a challenge into the future and probably won’t be left behind anytime soon.

Shreeya: Hmmmm, you mentioned debt-covenants - I think that is ringing an IAS 1 bell, which pertains to the current and non-current split of our liabilities. Those numbers are quite important to investors from a liquidity perspective.

Ronel: Yes, does bring to mind IAS 1 current/non-current classification issues in respect of loans.

It is important to remember that breaches of borrowing covenants focus on the legal rights of the entity rather than on the intentions of either of the parties to the loan. The liability’s classification is, however, unaffected by the entity’s intentions in the case of a breach of a loan agreement. If the entity does not meet a loan covenant, but it is not a breach (in other words it does not give the bank the right to call the debt) and the company has a period of grace available at the balance sheet date, the loan may still be classified as non-current. If the breach of debt covenant results in a breach of the loan agreement, the debt should be classified as current. This is an area that can be quite complex, depending on the legal terms of the loan agreement..

Last, but not least, a breach of loan covenant requires additional disclosure AND should probably be considered in the company’s going concern assessment.

Shreeya: From covenants to Covid ! Two big “Cs” - it is clear that COVID – 19 will have long lasting negative economic impacts and has also accelerated the forces of change which have been disrupting the Retail Industry globally.

I think, to add to your points on capital management, Ronel, retailers that have significant credit books really need to think carefully about the customer’s ability to repay their accounts - and how that will impact their expected credit loss assessment from an IFRS 9 perspective. Given that ECL is a forward looking assessment, the macroeconomic issues created by COVID-19 will certainly not disappear once we the pandemic does.

Ronel: Agreed!

Shreeya: Thank you Ronel for those insights!

We’ve covered quite a bit in today’s podcast. We touched on IFRS 16 transition and covered the hot topic of accounting for a modification in your lease when you downsize, or give up, a portion of your lease. That’s going to be important to remember if you’re leasing a store premises and want to effectively downsize your existing lease.

We then discussed debt covenants and some key considerations on current/non-current classification for the face of the balance sheet. And - now we’ve come to the topic of IFRS 9’s ECL.

Speaking of forward looking information, listeners have a lot to look ‘forward’ to in terms of the future podcasts in this series, unpacking more topical issues and more in the Retail Industry.

Thank you for joining us today, Ronel, and I hope you’ll be back again to share some knowledge with us.

Ronel: Thank you!

Shreeya: “This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors”