Tesco PLC – Half year report – 24 August 2019
Note 22 Changes in accounting policies – IFRS 16 ‘Leases’
This note explains the impact of the adoption of IFRS 16 ‘Leases’ on the Group’s financial position and financial performance.
IFRS 16 is effective for the accounting period commencing 24 February 2019. The Group adopted the standard retrospectively, with comparatives restated from a transition date of 25 February 2018.
IFRS 16 requires lessees to recognise right of use assets and lease liabilities on balance sheet for all leases, except short-term and low value asset leases. At commencement of the lease, the lease liability equals the present value of future lease payments, and the right of use asset equals the lease liability, adjusted for payments already made, lease incentives, initial direct costs and any provision for dilapidation costs.
For pre-IFRS 16 operating leases, the rental charge is replaced by depreciation of the right of use asset and interest on the lease liability.
IFRS 16 therefore results in an increase to operating profit, which is reported prior to interest being deducted. Depreciation is charged on a straight-line basis, however, interest is charged on outstanding lease liabilities and therefore reduces over the life of the lease. As a result, 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 rental charge they replace and therefore IFRS 16 is dilutive to EPS. For a mature portfolio, they are lower and therefore IFRS 16 is accretive. The Group’s lease portfolio on transition is relatively immature, being approximately one-third through an average total lease term of 26 years.
Under IFRS 16, the lease liability is remeasured upon the occurrence of certain events, such as a change in lease term or a change in future lease payments resulting from a change in an index or rate (for example, inflation-linked payments or market rate rent reviews). A corresponding adjustment is made to the right of use asset. Over three-quarters of the Group’s lease liability on transition is subject to inflation-linked rental uplifts. The Group no longer recognises property provisions for onerous lease contracts as the lease payments are included within the lease liability.
The Group applied the practical expedient not to reassess whether a contract is, or contains, a lease on transition. The Group has elected to recognise payments for short-term leases and leases of low value assets on a straight-line basis as an expense in the income statement.
IFRS 16 has not had a significant impact on the Group’s existing finance leases or on leases in which the Group is a lessor.
The most significant IFRS 16 judgements and estimates include the determination of lease term when there are extension or termination options, the selection of an appropriate discount rate to calculate the lease liability and the impairment of right of use assets. See Note 1 for further information.
The Group’s lease portfolio consists of retail, distribution and office properties and other assets such as motor vehicles.
IFRS 16 has a significant impact on reported assets, liabilities and the income statement of the Group, as well as the classification of cash flows relating to lease contracts. The standard impacts a number of key measures such as operating profit and cash generated from operations, as well as a number of alternative performance measures used by the Group. Further details on the impact of IFRS 16 can be found in the Group’s ‘Introducing IFRS 16’ analyst and investor briefing held on 15 February 2019 and available on http://www.tescoplc.com/investors/reports-results-and-presentations.
Balance sheet restatement
The tables below set out the impact of IFRS 16 on the transition balance sheet at 24 February 2018 and on the comparative period balance sheets as at 25 August 2018 and 23 February 2019 and related debt measures. Right of use assets (net of any impairments) and lease liabilities are presented separately on the face of the balance sheet. Net debt, which includes lease liabilities, increases. Total indebtedness also increases as the IFRS 16 lease liability exceeds the discounted operating lease commitments previously included. Provisions decrease as onerous lease provisions are replaced by impairments of the right of use assets. Trade and other payables reduce as accruals for straight line rental expense on leases with fixed rent increases are eliminated. Trade and other receivables also reduce as lease prepayments are eliminated. A deferred tax asset is recognised on the transition adjustment.
The following footnotes relate to the balance sheet restatement tables presented below:
(a) The estimated impact of adopting IFRS 16 on the Group’s Gain Land Limited associate has been updated to reflect new, more detailed, information received.
(b) Net debt comprises bank and other borrowings, lease liabilities, net derivative financial instruments, joint venture loans and other receivables/payables, offset by cash and cash equivalents and short-term investments. It excludes the net debt of Tesco bank, which has lease liabilities of £36m as at 24 February 2018, £35m as at 25 August 2018 and £35m as at 23 February 2019.
(c) Total indebtedness pre-IFRS 16 comprises Net debt plus the IAS 19 deficit in the pension schemes (net of associated deferred tax) plus the present value of future minimum lease payments under non-cancellable operating leases. Post-IFRS 16, lease liabilities are included in Net debt, replacing the present value of future minimum lease payments under non-cancellable operating leases.
Income statement restatement
The table below sets out the impact of IFRS 16 on the comparative period income statement for the 26 weeks ended 25 August 2018 and related APMs. Cost of sales and administrative expenses reduce and finance costs increase as straight line operating lease rental expense is replaced by depreciation of the right of use asset and interest on the lease liability. This results in higher gross profit, operating profit and operating margin. As the interest expense is front-end loaded and decreases as the lease liability decreases, profit before tax is lower in the early stages of a lease and higher in the later stages when compared to a straight-line rental expense.
Cash flow statement restatement
The table below sets out the impact of IFRS 16 on the comparative period cash flow statement for the 26 weeks ended 25 August 2018 and related APMs. IFRS 16 has no impact on total cash flow for the period or cash and cash equivalents at the end of the period. Cash generated from operations and free cash flow measures increase as operating lease rental expenses are no longer recognised as operating cash outflows. Cash outflows are instead split between interest paid and repayments of obligations under leases, which both increase.
Note 1 Basis of preparation (extract 1)
Adoption of new IFRSs
The Group has adopted IFRS 16 ‘Leases’ effective for the period ending 24 August 2019. IFRS 16 has been applied fully retrospectively and comparatives for the prior periods have been restated. Further details of the impact of adoption of IFRS 16 is described in Note 22.
Note 1 Basis of preparation (extract 2)
The Group assesses whether a contract is, or contains a lease at inception of the contract. A lease conveys the right to direct the use and obtain substantially all of the economic benefits of an identified asset for a period of time in exchange for consideration.
The Group as a lessee
A right of use asset and corresponding lease liability are recognised at commencement of the lease. The lease liability is measured at the present value of the lease payments, discounted at the rate implicit in the lease, or if that cannot be readily determined, at the lessee’s incremental borrowing rate specific to the term, country, currency and start date of the lease. Lease payments include: fixed payments; variable lease payments dependent on an index or rate, initially measured using the index or rate at commencement; the exercise price under a purchase option if the Group is reasonably certain to exercise; penalties for early termination if the lease term reflects the Group exercising a break option; and payments in an optional renewal period if the Group is reasonably certain to exercise an extension option or not exercise a break option.
The lease liability is subsequently measured at amortised cost using the effective interest rate method. It is remeasured, with a corresponding adjustment to the right of use asset, when there is a change in future lease payments resulting from a rent review, change in an index or rate such as inflation, or change in the Group’s assessment of whether it is reasonably certain to exercise a purchase or extension option or not exercise a break option.
The right of use asset is initially measured at cost, comprising: the initial lease liability; any lease payments already made less any lease incentives received; initial direct costs; and any dilapidation or restoration costs. The right of use asset is subsequently depreciated on a straight line basis over the shorter of the lease term or the useful life of the underlying asset. The right of use asset is tested for impairment if there are any indicators of impairment.
Leases of low value assets and short term leases of 12 months or less are expensed to the income statement, as are variable payments dependent on performance or usage, ‘out of contract’ payments and non-lease service components.
The Group as a lessor
Leases are classified as finance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership to the lessee. All other leases are classified as operating leases. Where the Group is an intermediate lessor, the sub lease classification is assessed with reference to the head lease right of use asset. Amounts due from lessees under finance leases are recorded as receivables at the amount of the Group’s net investment in the lease. Finance lease income is allocated to accounting periods so as to reflect a constant periodic rate of return on the Group’s net investment in the lease. Rental income from operating leases is recognised on a straight-line basis over the term of the lease.
Sale and leaseback
A sale and leaseback transaction is where the Group sells an asset and immediately reacquires the use of the asset by entering into a lease with the buyer. A sale occurs when control of the underlying asset passes to the buyer. A lease liability is recognised, the associated property, plant and equipment asset is derecognised, and a right of use asset is recognised at the proportion of the carrying value relating to the right retained. Any gain or loss arising relates to the rights transferred to the buyer.
Critical accounting judgements (extract)
Management exercises judgement in determining the likelihood of exercising break or extension options in determining the lease term. Break and extension options are included to provide operational flexibility should the economic outlook for an asset be different to expectations, and hence at commencement of the lease, break or extension options are not typically considered reasonably certain to be exercised, unless there is a valid business reason otherwise.
The discount rate used to calculate the lease liability is the rate implicit in the lease, if it can be readily determined, or the lessee’s incremental borrowing rate if not. Management uses the rate implicit in the lease where the lessor is a related party (such as leases from joint ventures) and the lessee’s incremental borrowing rate for all other leases. Incremental borrowing rates are determined monthly and depend on the term, country, currency and start date of the lease. The incremental borrowing rate is determined based on a series of inputs including: the risk free rate based on government bond rates; a country specific risk adjustment; a credit risk adjustment based on Tesco bond yields; and an entity specific adjustment where the entity risk profile is different to that of the Group.
Refer to Note 11 for additional disclosures relating to leases.
Alternative performance measures (APMs) (extract)
Changes to APMs
As a result of adopting IFRS 16 in the current period, the Directors and management have applied the following changes to the Group’s APMs:
• Free cash flow and Retail free cash flow have been redefined to include ‘Repayments of obligations under leases’. The impact of adopting IFRS 16 has been to replace rental payments presented within operating profit with a combination of interest payments and capital repayments of the lease obligation, with no overall change in total cash flow for the Group. Redefining Free cash flow and Retail free cash flow to include the capital repayments of obligations under leases ensures that the Group’s reported free cash flow measures are consistent with those previously reported.
• Total indebtedness has been redefined to no longer include the present value of future minimum lease payments under non-cancellable operating leases. Following the adoption of IFRS 16, the Group’s measure of Total indebtedness includes lease liabilities (with the exception of short-term and low value asset leases).
• The fixed charge cover denominator has been redefined to exclude interest on lease liabilities from net finance costs and include all lease payments made in the period. Amending the calculation ensures that all cash payments made in the period with respect to the Group’s leases continue to be included in the calculation of fixed charge cover.
Note 11 Leases
Group as lessee
Lease liabilities represent rentals payable by the Group for certain of its retail, distribution and office properties and other assets such as motor vehicles. The leases have varying terms, purchase options, escalation clauses and renewal rights. Purchase options and renewal rights, where they occur, are at market value. Escalation clauses are in line with market practices and include inflation-linked, fixed rates, resets to market rents and hybrids of these.
In prior years, the Group entered into several joint ventures and associates, and sold and leased back properties to and from these joint ventures and associates over 20 to 30 year terms. On certain transactions, the Group has an option to buy back either the leased asset or the equity of the other party, at market value and at a specified date, typically at year ten. On some of these transactions the Group also has a lease break option, which is exercisable if the buy back option is exercised and the associated debt in the joint venture or associate is repaid. The lease liability in respect of these leases assumes that the lease break option is not exercised.
On 13 September 2018, the Group exercised its option to buy back the 50% equity holding in the Tesco Atrato Limited Partnership held by the other joint venture partner. The acquisition completed on 23 September 2019. Refer to Note 21. There were no lease break options on the associated property leases from the joint venture and hence the lease liabilities on balance sheet currently reflect the full lease terms. On completion, these leases become intercompany leases and will be eliminated on consolidation.
The following tables show the discounted lease liabilities included in the Group balance sheet and a maturity analysis of the contractual undiscounted lease payments: