IFRS 16 compliance for retail companies has a lot to do with renting physical store premises. As managing the lease contracts is essential to maintaining market presence, finance teams in the retail industry know they have several unique challenges reporting IFRS 16 leases. Here’s what to consider – and how to solve for it.
When we ask CFOs, controllers and accountants in retail companies what is unique about their professional challenges, they tell us there are at least half a dozen typical retail challenges:
- Inventory: Finance teams are responsible for managing inventory turnover and stock levels. In the face of seasonal demand, it can be particularly challenging to balance supply and demand, avoiding overstocking or stockouts, and managing perishable goods.
- There is always a season: Finance teams are well aware that seasonal variations in revenue and expenses demand tight management of cash flow during peak and slow periods, including to ensure that adequate resources are available to meet high demand.
- Pricing: Finance teams are on a never-ending quest to master competitive and profitable pricing while considering discounts, promotions, and markdowns. Finance teams analyze pricing strategies to determine the optimal balance between attracting customers and maintaining profitability.
- Multi-channel sales: Managing different sales channels, tracking cross-channel customer behavior, and integrating data for accurate financial reporting can be complex. Online sales involve additional E-commerce considerations such as payment processing, cybersecurity, order fulfillment, and returns management.
- Sustainability and ESG reporting: When the customer is the general public and your activities are highly visible, environmental, social, and governance (ESG) considerations are especially important. Finance teams are responsible for gathering and reporting relevant data on ESG metrics and integrating sustainability into financial reporting.
- Lease and Rent Contracts: Most retailers lease store spaces and equipment. In addition to managing the agreements, finance teams are responsible for complying with the lease accounting standards (such as IFRS 16).
The retail industry and IFRS 16
Before, lease management teams in retail companies could work separately from the finance team. With lease accounting under IFRS 16, they both play an important role in providing accurate information for the financial statements.
Since 2019, IFRS reporting companies have had to follow the IFRS 16 lease accounting standard. The finance team needs to consider how all events during a lease's lifetime affect its value, which must be accounted for on the balance sheet.
Retail companies often have a significant number of lease agreements for their physical locations, which they use to operate their stores and manage their inventory. These leases can vary in terms of lease length, payment structure, and other lease terms. The implementation of IFRS 16 requires these leases to be recognized on the balance sheet as right-of-use assets and lease liabilities.
The IFRS 16 accounting rules has a clear impact on how retail companies do their financial reporting. They need to look at how the lease standard affects things like their current business operations, contracts they make, budgets, important measurements, computer systems, and how they control their processes.
For companies that have many leases, like those that rent store spaces, it's really important to gather all the right information about these leases and also keep track of any new ones. It may include using new lease management software, and changing how they do things, which will take some time. Also, IFRS 16 affects financial statements, as well as things like loans and credit ratings.
We have been talking to hundreds of finance teams in the retail industry through the years. Often, they have been using Excel spreadsheets to handle IFRS 16 reporting. Our rule of thumb is that when the number of leases surpasses 15, the CFO should use a dedicated lease accounting software to comply with IFRS 16. Excel is simply not fit for purpose.
Our customer Europris has a long history of managing IFRS 16: "About 2 years before the new regulations, we started making models and forecasts to see how IFRS 16 would affect results. These were thorough and precise, if we may say so ourselves, but they had an obvious weakness: They were made in Excel, with all the limitations it had for ongoing management and maintenance, including dependence on key personnel. An IFRS 16 agreement consists of many elements, which are far better handled when working in a suitable software." Read the case study here.
Complex lease structures: The impact of IFRS 16 on the retail industry
Compliance is often more challenging for retail companies, as they often have complex lease structures. Each type of store lease may have different lease terms, payment structures, and accounting treatment, making it challenging for finance teams to accurately account for and manage these leases.
Many retail companies operate in several national markets, thus they may have leases in multiple countries with different lease accounting standards and regulations. Finance teams must navigate these complexities and ensure compliance with various accounting standards such as IFRS and local GAAP.
Like in most industries, lease modifications and renewals are common due to changing business needs and market conditions. Finance teams must properly account for these changes and understand their implications on financial statements.
For retail companies with many lease agreements, this can be overwhelming. Using one spreadsheet for each lease to track all payments, renewals, changes, and discounts can be a big headache and lead to errors.
To overcome these challenges, finance teams in the retail industry may need to invest in specialized lease accounting software, not least to ensure cross-functional collaboration between finance and operations teams.
Financial reporting under IFRS 16 for retail companies
Here are a few specific ways in which IFRS 16 affects financial statements in a retail company (and in most other industries, too):
Balance sheet: Lease liabilities and right-of-use assets will be added to the balance sheet, giving a more complete picture of a company's liabilities and assets. This also means that the equity section of the balance sheet will also be affected, as the lease liabilities are a form of long-term liabilities and will decrease equity.
Profit and loss statement: Lease payments, which were previously classified as operating expenses, will now be split into an interest expense and amortization of right-of-use asset in the income statement, which may affect the company's profitability measures.
Cash flow statement: The lease payments will now be split between the financing activities and operating activities section of the cash flow statement, reflecting the financing nature of leases.
IFRS 16 lease disclosures for retail companies: Companies will be required to provide additional disclosures in the notes to the financial statements about the nature of their leases, the amount and timing of lease payments, the lease term and the carrying amounts of their lease liabilities and right-of-use assets.
Lease management for retail companies
Certain elements of store rental contracts are excluded from the lease liabilities and right-of-use assets calculations. According to PwC, these elements typically include:
- Variable lease payments dependent on future events: Payments that are contingent on future factors, such as sales percentage-based rent, are not included in the initial calculation of lease liabilities and right-of-use assets. They are recognized in the income statement when the event triggering the payment occurs.
- Non-lease components: Retail lease contracts often include non-lease components like maintenance, common area expenses, property taxes, and insurance. These costs are separated from the lease components and are accounted for separately as operating expenses, rather than being included in the lease liabilities and right-of-use assets.
- Initial direct costs that are not incremental: Direct costs incurred by the lessee that do not qualify as incremental costs to obtain a lease are not capitalized as part of the right-of-use assets. Incremental costs, on the other hand, should be added to the initial measurement of the right-of-use asset.
Transition to IFRS 16 for retail companies
IFRS 16 compliance in a retail company involves a complex process. It can be time-consuming and professionally challenging. Here are six steps that need to be taken:
- Identify leases: Companies will need to review all of their existing contracts to determine which ones qualify as leases under IFRS 16.
- Assess the lease term: The lease term is the period over which the company has the right to use the store or other asset. The lease term should include any options to extend or terminate the lease that are reasonably certain to be exercised.
- Determine the lease payments: The lease payments are the payments to be made by the company over the term of the lease – for each lease. This includes any variable lease payments that depend on an index or a rate.
- Determine the discount rate: The discount rate is the rate used to calculate the present value of lease payments. It's typically the company's incremental borrowing rate, which is the rate that the company would have to pay to borrow the funds necessary to purchase the physical premises.
- Recognize right-of-use assets and lease liabilities: Once the lease payments, term, and discount rate have been determined, companies will need to recognize a right-of-use asset and a lease liability on their balance sheet for each lease. The right-of-use assets should be amortized on a straight-line basis over the lease term, and the lease liability should be recorded at the present value of the lease payments.
- Disclose relevant information: Companies will also need to provide additional disclosures in the notes to the financial statements about the nature of their leases, the amount and timing of lease payments, and the carrying amounts of their lease liabilities and right-of-use assets.
Can lease accounting software help a retail company?
Our rule of thumb is that when the number of leases for stores or other assets surpass 15, the CFO should use a dedicated lease accounting software to comply with IFRS 16. Most retail companies have far more than 15 leases. So, should you be looking for a solution inside or outside of the ERP system?
The Enterprise Resource Planning (ERP) is the backbone of digital tools used by the finance department. When ERP is used at its best, financial data in a retail company is linked together. Also linked, are data from systems for production, e-commerce, payroll, HRM and CRM.
In a retail company, there are a significant number of software that retrieves data from ERP and that creates data for ERP. Such software may or may not offer seamless ERP integrations. Invoice dispatch systems and incoming invoice processing systems, which meet national requirements, are familiar to most people. Period-end closing, reporting and budgeting are other examples of processes that are supported by solutions other than ERP.
We have dived into why also lease accounting software should coexist with the ERP, described in this article. In another article, we offer a comprehensive checklist for CFOs looking for lease accounting software to help the company comply with IFRS 16.
