James knew it would be a bad day. He could feel it in his bones.
He had just returned from an analysts' meeting in the City. Distributors plc had announced its 2002 results to the stock market a few days before and these had been broadly well received. The turnaround process was just about complete after a torrid 18 months. The group had swung back into profit and maintained its dividend. The CEO had managed to curb his irrational exuberance towards sales expectations, and despite this more cautious stance the share price had moved ahead.
James had adopted more conservative accounting policies. The pension fund exposure had been reduced through a switch into gilts. The deferred tax hit in the accounts, from implementing, had reduced distributable reserves. Dividend cover was still too low and gearing levels too high at almost 90%, but the group was in far better shape now and moving in the right direction.
This had been the last meeting. The analyst had queried whether International Accounting Standards would change the results and James had said he would give him a call in the afternoon once he had the details at his finger-tips. James had been fairly relaxed on this point. Whatever the accounting changes were, they would not affect future cashflow projections and it was just a matter of explaining this to the analyst community. Provide them with a reconciliation back to EBITDA and everyone would be happy.
The financial controller and group treasurer arrived in his office, ready to discuss IAS.
'Hannah, please run me through your thoughts on IAS and how it might affect us,' James began. Hannah was the bright new financial controller who had just joined the company, and her first job following the results announcement was to look into this area. She spent the first five minutes qualifying her analysis, noting she had not yet spoken to the auditors or any other advisers, wanting to review it again internally, etc etc.
She also noted there were going to be new formats for the p&l, balance sheet and cashflow statement. She had not yet looked at the p&l charge required from the proposed accounting treatment of share options. By the time she finished James was beginning to feel uncomfortable.A leases problem?
'I am not sure if we have a problem on leases,' she continued. 'From what I can see some of our operating leases might be classified as finance leases under the new IAS, and that would push our gearing up. It seems that there is a risk underthat part of our operating lease spend will be reclassified as finance leases. We have always been able to justify in the past that our leases represent less than 90% of the estimated useful life of the assets under SSAP 21. The approach under does not include the 90% test and they split the treatment of land and the building sitting on the land. As our leases are generally around a 25-year maturity, and I understand the buildings' expected lives are about the same length, the building element of the operating lease will need to be treated as a finance lease. We apparently do not need to do the same thing with the land element as its useful economic life is much longer.'
'Hannah, how material is all this?' queried James. 'Well, very crudely, the maths runs as follows. Each site has an average annual rental of approximately 100,000, and if we discount that by the current market property yield of 6% we get a discounted value per site of just less than 1.2m. The property department thinks that approximately 30% of the value is attributable to the building alone, so I make the finance lease on the building approximately 380,000. If you gross this up across our 100 sites, that amounts to finance lease obligations of 38m.'
'But that would increase our gearing to …'
'300%,' interjected Hannah as James struggled to complete the mental arithmetic. 'As I explained I need to do more work on this to make sure it is right before we can reach any firm conclusions. We do need to speak to the auditors on this and make sure we have got the interpretation right.
However, I am reasonably certain at the moment that the principles at least are correct.'
James was already reaching for the phone when she said, 'But there could be other issues we also need to check out.'
'Go on,' he said. Hannah was looking around for a bit of moral support from William, the group treasurer, but he showed no inclination to be drawn into the line of fire.
'We have to applyat some point, although we still do not know if will be identical in its requirements,' she said. 'We disclosed a pension fund deficit in the notes to the accounts of 5m in excess of the current provision under SSAP 24. This additional amount would need to be written off when is implemented, thereby reducing shareholders' funds and increasing gearing. And', she added, 'we are trying to understand the implications of , but William has been looking at this.' Looking somewhat relieved, she handed over to the group treasurer. A currency problem?
'is still under discussion and we are not completely sure how it is going to be applied. However, we believe at this stage that our foreign exchange cover on imports will still be classified as hedging activity and we will be able to apply hedge accounting. As you know, we enter into forward foreign exchange contracts to protect the value of our imports for the next 12 months,' William said. 'We discussed this policy at length with the board several months ago and agreed to continue with it. We have applied it continuously for the last five years and explained it on several occasions to the analysts and our institutional investors who all seem quite happy with our approach. There is a full disclosure of this in the operating and financial review where we explain the rationale for the hedging activity and note that it benefits us in some years and costs us in others,' he added. 'It does however reduce the variability of our cashflows over time. In addition we show the unrecognised gains and losses on our currency contracts in the financial instruments note in the annual report.'
'So what is the problem?' asked James.
'Wellproposes that the unrecognised gains or losses should be included in the group balance sheet despite the fact these contracts are hedging future trading cashflows which are not yet reflected in the accounts,' William replied. 'At the end of 2002 we had a 7m unrealised loss on the foreign exchange contracts. Under the hedging treatment it would be shown on the balance sheet and also as a deduction from equity shareholders' funds, possibly the profit and loss reserve.'
They huddled over a sheet of paper and sketched out the implied amendments to the 2002 balance sheet (see table).
'So,' declared James, 'I now have gearing, including finance leases, of 800% under IAS instead of 90%. It also looks as if I might struggle to pay a dividend if these foreign exchange differences are knocked off distributable reserves!'
'It might actually be worse,' interrupted William. 'Under the articles of association we are not permitted to borrow more than three times shareholder funds. I do not think the finance leases count as borrowings for these purposes, but our seasonal working capital swing could put us over this limit. At that level the additional borrowings are ultra vires and the directors become personally liable.'
'However', he added, 'it very much depends on how all the definitions work. We might well be able to argue that the foreign exchange exposures are unrealised, and we can ignore them in calculating our realised profits out of which we can pay dividends. Also the borrowing powers in the articles of association were drafted a long time ago. It is possible that any foreign exchange deduction from equity in the consolidated accounts does not need to be deducted when doing the borrowing powers calculation. Also finance leases may fall outside the borrowings definition in the articles. There is a chance we might not be in such a bad position, but it is all very unclear at the moment and I understand that there will be more technical pronouncements on these issues in the next few months. I suspect the audit committee will want a professional opinion on these matters.'
At that moment James knew he was not introducing any new accounting standards until he absolutely had to. He also made a mental note to increase the professional fees budget.
Hannah and William gratefully retired from his office. Eventually James picked up the phone and rang the analyst.
After a few pleasantries James explained that the application of the IAS was still subject to debate and that Distributors plc would only adopt them once industry consensus had become apparent. He did not want to say any more as he was not sure what might be price sensitive and what not, and did not want to put the analyst in an awkward position. They both agreed to pick it up again after the next results announcement.
Now what was he going to do before he broached the subject with his CEO?
|Consolidated balance sheet||Finance lease adjustment||Foreign exchange adjustment||Additional pensions provision||Revised balance sheet|
|Net working capital||26||26|
|Deferred tax provisions||-7||-7|
|Net debt/finance lease gearing||89%||900%|