Tesco and RBS financial reporting hit by IFRS 16 Leases

Tesco is the latest company to flag up the negative impact of the latest IFRS 16 lease accounting standard on its balance sheet, with a projected £101m drop in profit before tax, while Royal Bank of Scotland results also hinted at the cost of future implementation

The supermarket giant also noted £3.3bn increase in indebtedness when it restated its first half 2018/19 results to reflect IFRS 16 Leases, although the company is yet to adopt the standard.

IFRS 16 is effective for all accounting periods beginning on or after 1 January 2019. Tesco's first reported accounting period under IFRS 16 will be the 2019/20 financial year, which runs from 24 February 2019 to 29 February 2020.

The group intends to adopt the standard fully retrospectively, and the first half 2018/19 financial statements, restated for IFRS 16, will form the prior period comparative numbers for the first published IFRS 16 accounts in October 2019. 

In a briefing for analysts, Tesco stated that while IFRS 16 has no economic impact on the group, it does however have a significant impact on the way the assets, liabilities and the income statement are presented, as well as the classification of cash flows relating to lease contracts.

Among the changes, group operating profit1 increases by £188m to £1,121m as rent is removed and only part-replaced by depreciation; group operating margin increases by 59 basis points to 3.53%.

Profit before tax and diluted EPS both decrease, by £101m and 91p respectively, due to the combination of depreciation and interest being higher than the rent they replace. This is due to the relative immaturity of the group's lease portfolio, with leases being around one-third expired on average.  The proportion of EPS dilution will reduce as the portfolio matures and, most notably, as underlying earnings increase.

Net assets reduce by £1.4bn to £13bn, as a 'new' lease liability of £10.6bn and 'new' right of use asset of £7.8bn are recognised and onerous lease provisions and other working capital balances are derecognised.

Total indebtedness increases by £3.3bn to £15.8bn due to lease extensions and contingent commitments being included and lease-specific discount rates being applied.

Tesco notes the impact on the income statement below operating profit is highly dependent on average lease maturity.  For an immature portfolio, depreciation and interest are higher than the rent they replace and therefore IFRS 16 is dilutive to EPS. For a mature portfolio, they are lower and therefore IFRS 16 is accretive.

Royal Bank of Scotland – IFRS impact

RBS has also highlighted the impact of IFRS 16 on its results for the year, which saw the banking group report an operating profit before tax of £3,359m and an attributable profit of £1,622m for 2018.

The bank said it expects to end 2019 with risk weighted assets (RWAs) of around £185bn– £190bn. RBS stated: ‘While we remain comfortable with our 2020 target of a return on tangible equity of more than 12%, we recognise our 2020 target of a cost:income ratio of less than 50% is increasingly challenging for the business to achieve with the risk being to the downside.

‘This reflects the ongoing economic and political uncertainty and the additional ongoing costs associated with ringfencing and Brexit.’

The commentary also points out that it expects an increase in RWAs as a result of IFRS 16, which requires lease obligations to be brought on balance sheet, of £1.3bn in 2019. 

The annual report also noted: ‘IFRS 9 [Financial Instruments] adoption on 1 January 2018 favourably impacted CET1 by 30 basis points. RWAs reduced by £12.2bn to £188.7bnprimarily driven by the legacy business in NatWest Markets, the impact of capital initiatives in Commercial Banking and the impact of the non-performing loan sale and improvement in credit metrics in Ulster Bank RoI.’

The overall provisioning requirement under IFRS 9 increased by £616m – a 16% increase relative to IAS 39. The main driver of the increase was the requirement to hold a minimum of 12 months of ECL on performing assets, increasing to lifetime loss for assets that have exhibited a significant increase in credit risk.

Compared with the latent loss provision held under IAS 39 of £390m, the ECL requirement on performing assets (Stage 1 and Stage 2) more than doubled, increasing by £479m to £869m.

The IFRS 9 provisioning requirement on non-performing assets was less affected. The ECL requirement of £3.6bn was £123m (4%) higher compared with IAS 39 impaired portfolio provisions of £3.4bn principally on defaulted assets that did not carry a provision.

Report by Pat Sweet

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