AASB 16 accounting standards tying retailers in knots

Treatment of leases has become a major accounting headache for the big retailers and their shareholders. Picture: Supplied

A new set of accounting standards is creating chaos for many audited corporate balance sheets and making it very difficult for those who use net tangible asset backing as part of their portfolio evaluations. And its also distorting earnings, forcing companies to ignore accounting standards in their direct messages to small shareholders. Nowhere is the chaos better illustrated then in our two outstanding retailers, Coles and Woolworths.

The June 28 balance sheet of Coles, released this week, arguably showed negative shareholders, funds calculated on a traditional net tangible asset basis. Woolworths has yet to release its June 30 balance sheet, but at December 31 it had a similar problem.

The confusion in the Coles and Woolworths balance sheets, along with many other large retailers, has coincided with recent large bond issues by both Woolworths and Coles. Both bondholders and shareholders are ignoring the asset messages in the official accounts.

For decades, many in the accounting profession have wanted to incorporate into balance sheets the long and short term liabilities created by lease contracts. These liabilities were incorporated into the accounts via the notes, but were not in the formal balance sheet.

And so, an accounting standard called a AASB 16 passed through the myriad of approval processes and came into operation on July 1, 2019.

Under AASB 16, liabilities for lease contracts must be incorporated in the balance sheet among all other liabilities. But this required an offsetting asset and so a highly theoretical asset – called the “right to use” the leased assets – was installed on the assets side. The actual mechanism used in this manoeuvre not only causes balance sheet problems but distorts statutory earnings.

So in the Coles statutory accounts prepared under AASB 16 operating lease expenses are no longer recognised (a nonsense) and are replaced by depreciation of the “right to use” asset.

As a result Coles statutory group earnings before interest and tax (EBIT) actually rose by $317m but profit after tax fell by $17m. Realising the chaos being created by the standards, Coles announced two sets of results – one using what they think is right set of rules and one using International Financial Reporting Standards (IFRS). That’s really tough for smaller shareholders. With the accountants out of touch, most professional share analysts have created their own accounting standards.

Each year, under law, companies are required to state their net tangible asset backing per share.

The June 28 Coles audited accounts declared that the right to use a leasehold property was a “tangible asset”. By all old-style conventional accounting traditions the right to use an asset is not a tangible asset. But if Coles had not classified this right as a tangible asset it would have had its net tangible asset backing as a negative. So the bizarre situation is created whereby unless we have “right to use” asset” as a tangible asset then one of Australia’s largest companies by market capitalisation has a negative tangible asset backing per share. Woolworths is a larger company and will have exactly the same problem when it prepares its June 30 accounts. It makes a nonsense of the accounting process.

For the record, the actual method of incorporating the right to use assets as a tangible asset and adopting AASB 16 still caused Coles net tangible asset backing to slump from $1.36 to 76c. Without the AASB 16 gymnastics, it would have risen to $1.40.

Coles has $8.9bn in future lease liabilities and $7.7bn in the value of the “right to use” those leases. In Woolworths future lease liabilities calculated at December 31 are $14.4bn -almost twice the level of Coles. Woolworths “right to use” leasehold assets is $12bn. In both Coles and Woolworths, if the right to use leasehold assets is classified as an intangible then tangible assets become a negative.

It’s true that the accounting treatment does highlight to shareholders how our major retailers are cash machines based on large lease agreements.

But if anything goes wrong with a retailer that has big lease agreements, then it will threaten its survival. Around the retail scene, large and small retailers, led by Solomon Lew’s Premier Investments, are trying to reduce lease rentals.

If a retailer gets into trading bother then their “right to use” assets become next to worthless. That’s why to everyone outside the auditors and standard setters, the “right to use” asset is an intangible. It’s going to take many years, but chief financial officers have to start the long process of reversing a standards that do not work for the people who use accounts, led by small investors.