Tesco PLC – Annual report – 23 February 2019
Note 36 Changes in accounting policies (extract)
Standards issued but not yet effective (extract)
IFRS 16 ‘Leases’
IFRS 16 ‘Leases’ will be effective in the Group financial statements for the accounting period commencing 24 February 2019. The Group will adopt 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 will no longer recognise property provisions for onerous lease contracts as the lease payments are included within the lease liability.
The Group has 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 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.
The Group’s lease portfolio consists of retail, distribution and office properties and other assets such as motor vehicles.
The Group’s IFRS 16 Project is governed by a Steering Committee, which regularly reports progress to the Group Audit Committee. The Group has finalised its IFRS 16 accounting policies, determined the appropriate discount rates to apply to lease payments, selected and implemented an IT system to collate and report lease data, established procedures and controls for accounting and reporting under IFRS 16 and established a process of parallel reporting for the comparative period.
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.
The tables below set out the expected impact of IFRS 16 on the transition balance sheet at 24 February 2018 and on the comparative year balance sheet as at 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.
(a) After restating for the adoption of IFRS 15 ‘Revenue from Contracts with Customers’.
(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 £35m (2018: £36m).
(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.
The table below sets out the expected impact of IFRS 16 on the comparative period income statement for the 52 weeks ended 23 February 2019 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. Profit before tax before exceptional items and amortisation of acquired intangibles decreases by £152m, whereas profit before tax (which includes the impact of exceptional impairment reversals of £56m and the reversal of exceptional onerous lease provision charges of £39m) decreases by £57m.
The table below sets out the expected impact of IFRS 16 on the comparative period cash flow statement for the 52 weeks ended 23 February 2019 and related APMs. IFRS 16 has no impact on total cash flow for the year or cash and cash equivalents at the end of the year. 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.
- Free cash flow has been redefined to include repayments of obligations under leases due to IFRS 16. This results in a minor adjustment of £17m, restating reported retail free cash flow of £906m to £889m. There is no overall impact to cash and cash equivalents at the end of the period.
Segmental reporting restatement
The tables below set out the expected comparative period segmental income statement for the 52 weeks ended 23 February 2019 and segmental balance sheet as at 23 February 2019, restated for the impact of IFRS 16. Refer to Note 2 for the reported segmental income statement and balance sheet.
(a) Excludes loans to joint ventures of £105m which form part of net debt.
(b) Excludes derivative financial instrument non-current assets of £1,178m.
(c) Excludes net interest and other receivables of £1m which form part of net debt.
(d) Excludes loans to joint ventures of £28m which form part of net debt.
(e) Includes lease liabilities in UK & ROI £9,060m, Central Europe £728m, Asia £682m, Tesco Bank £35m, Unallocated £nil and Total £10,505m.