TESCO International Accounting Standards Board jst Floor 30 Cannon Street Lou don EC4M 6X11 I 3 September 2013 Dear Boai-d Members, IASB Exposure Draft ED/2013/6 Leases 2013-270 Thank you for the opportunity to respond to the Exposure Draft ED/20 13/6 Leases (the ED ). This letter represents the views of Tesco PLC. Tesco PLC ( Tesco ) is a leading international grocery and general merchandising retailer headquartered in the UK. Tesco has 6,850 stores operating in 12 markets across Europe, Asia and the US, employing over 530,000 people. During the financial year ended February 2013, Tesco reported revenues of 64.8 billion and net assets of 16.7 billion. The minimum lease payments under operating leases were reported at 17.3 billion. 1. Introduction We acknowledge that the current proposals are an improvement to ED/2010/9 through the acceptance that different accounting models are needed to represent the different types of leases that exist in the commercial world. However, we believe that the proposed accounting for property leases under the Type B model is fundamentally incorrect and that the ED has not addressed the underlying conceptual flaws in the original proposals. Adopting the ED would be detrimental to the usefulness of financial statements. We recommend that property leases are not recognised on the balance sheet and that lease payments are recognised in the Income Statement on a straight line basis as this will result in a fair representation of such leases. Given the seriousness of the concerns that we have raised, we recommend that a robust consultation and consideration of alternative proposals is undertaken before any new accounting model is finalised. Our primary concerns with the proposals are summarised below. list of our detailed observations. Please refer to the Appendix for a 2. Flaws in Type B model The Type B model in particular contains a number of conceptual flaws and inconsistencies with existing IFRS requirements. We believe this to be an inevitable consequence of the attempt to resolve the Income Statement issues in the previous Exposure Draft whilst still forcing leases which are nonfinancing in nature onto the balance sheet. The primary and significant flaws that we see in the Type B model are summarised below: Balance Sheet The measurements of right-of-use assets and lease liabilities lack measurement lacks meaning and provide false assurance because: meaning i) the balance sheet amortisation is effectively a balancing item between the straight line lease expense and the unwinding of the discount on the associated lease liability which results in meaningless net book values of right-of-use assets; and Tesco Stores Ltd, (519500). Company Registered in England. Registered Office: Tesco House, Delamare Road, Cheshunt, Hertfordshire EN8 9SL
meaning 2013-270 ii) the measurement bases only provide a partial view of leases because they exclude certain variable payments. Volatility in the l3alance Sheet and Income Statement There will be volatility in the balance sheet and income statement that does not have commercial substance as the lease assets and liabilities have not fundamentally changed since inception. The volatility is a result of re-measurement requirements and renewal of expiring leases. Impairment issues Inappropriate impairment or masking of impairment ruirements may result from: i) the meaningless net realisable value of the right-of-use asset with back loaded amortisation as described above; and ii) discount rates used to determine the value of right-of-use assets being different to discount rates used to determine the recoverable amount of a CGU for impairment testing. We believe that the above listed flaws are inevitable under the proposed Type 13 model because the model forces recognition on the balance sheet of leases which are not financing in nature. This recognition causes fundamental issues that will appear either in the Income Statement as front loaded costs (as in FD/2010/9) or in the Balance Sheet as meaningless asset values (as under the current proposals). These issues cannot be eliminated as long as the Balance Sheet recognition concept is applied to leases which are not financing in nature. Adopting the Type 13 model would result in a misleading Balance Sheet and will be detrimental to users of financial statements. 3. Property leases As properties are very different to other types of assets, we agree that the accounting for property leases should be considered separately. We also support the recognition of certain types of leases, which are financing in nature, on the balance sheet. For property leases, there is often no alternative property available for use and any lease arrangement is motivated by the business need for the underlying asset rather than a financing decision. In addition, the terms of property leases, such as lease lengths, are dictated by the long term commercial objectives of the property owners. For example, buying the property is often not an option ofthred by the owner who may only be looking for a return on its investment. Therefore property leases are predominantly non-financing transactions and recognising a financing lease liability does not truly reflect the commercial substance of property leases. Due to the long term nature of properties, the leasing of properties is more akin to using the asset (rather than using it tip), or enjoying a service that the future economic benefits embodied in the asset are not consumed. This profile of enjoying a fixed period of a long life asset is not well represented by recognising an amortising asset on the balance sheet. In addition, fbr companies with significant numbers of property lease contracts, all other figures on the balance sheet will be dwartèd by the creation of meaningless right-of-use asset values and lease liabilities. This will have a significant distorting effect on key linancial ratios such as gearing and 2
return on capital employed. Such distortions will substantially compromise the ability of users of the financial statements to derive meaningful information about the underlying business. In summary, property leases should not be recognised on the balance sheet because: they are not financing arrangements; the future economic benefits associated with ownership of the underlying properties are unlikely to be used tip by the lessee during the lease term; the flaws in the Type B model, together with the size of some property leases, will significantly distort the overall picture presented on the balance sheet and through key financial ratios. 4. Conceptual flaws Under the proposals, all lease arrangements will give rise to a lease liability and a right-of-use asset, irrespective of their nature. We believe that for many lease arrangements, the existence of these liabilities and right-of-use assets does not satisfy the conceptual framework. Lease liability The conceptual framework delines a liability as a present obligation arising from past events. Unless a lease is in substance an asset purchase and associated financing arrangement, the signing of a lease contract at inception is not considered to be a sufficiently strong past event. This is because the lessor only fulfils their obligations during the lease term. In addition, the recognition of liabilities in relation to lease contracts would be inconsistent with other forms of exectitory contracts such as capital commitments, service agreements and agreements to buy inventories in the future. These items are not allowed to be recognised as liabilities on the balance sheet. As such, we do not believe that a liability can be recognised for all lease arrangements when applying the relevant definitions under the conceptual framework. Right-of-use asset An asset is defined by the conceptual framework as a resource controlled by the entity, thus the creation of a right-of-use asset indicates that all leased assets are controlled by the lessee. The existence of control suggests that a lessee holds all of the risks and rewards of ownership of an asset and can use it to derive value for the business in whichever way it chooses. In many cases, a lease contract does not transfer this level of control to a lessee. Furthermore, the right to use the asset may be revoked if lessors are not compensated during the lease term. As such, we do not believe that an asset can be recognised when applying the relevant definitions under the conceptual framework. Finance lease The proposed recognition and measurement of a lease liability will indicate that all leases are financing in nature. This treatment does not provide a faithful representation of some leasing transactions in that there are multiple reasons for entering into leasing arrangements and many of these do not relate to financing. We enter into leasing transactions for a broad range of commercial reasons, such as risk mitigation and operational flexibility. 3
In many cases, particularly with respect to long-lived assets such as property, there is often no alternative asset available for use and any lease arrangement is entirely motivated by the business need for the underlying asset rather than a financing decision. This is very different in substance to a leasing arrangement over readily available asset types for which lease arrangements entered into may represent the best financing solution that can be obtained from a range of suitable lessors and vendors. 5. Disclosures The disclosures requirements are lengthy, onerous and will detract user attention from other areas of the financial statements. A summary of the key disclosures requirement, listed below, clearly shows the unnecessarily extensive requirements to be imposed on preparers and users of financial statements: information about the nature of leases; information relating to subleases; information about leases that have not yet commenced but that create significant rights and obligations for the lessee; information about significant assumptions and judgements made; separate reconciliations of opening and closing balances of right-of-use assets by class of underlying asset or Type A and Type B lease arrangements; separate reconciliations of opening and closing balances of lease liabilities for Type A and Type B lease arrangements; for lessors, separate reconciliations of lease income for Type A and Type B lease arrangements; for lessors, a maturity analysis for lease receivables, and information about risk management; disclosures on sale and leasebacks. If the proposals resulted in a set of financial statements that show a true and fair reflection of the substance of leasing transactions, such extensive disclosure would not be necessary. The consequence of such an onerous level of disclosure requirement could be Uailure by companies to properly comply with it. 6. Conclusion We fully support the goal of improving lease reporting in order to meet the needs of users of financial statements and acknowledge that the new proposals are an improvement to ld/2oio/9 for nonproperty leases. I lowever, we believe that the proposed model for property leases provides a less fiuithful representation of the substance of leasing transactions than the existing accounting model under las 1 7. Furthermore, we consider that the proposals for property leases are conceptually flawed and introduce numerous inconsistencies when compared to other areas of IFRS and the conceptual framework. Ultimately, adopting this model would be detrimental to the usefulness of financial statements. We recommend that properties leases are not recognised on the balance sheet and that lease payments are recognised in the Income Statement on a straight line basis. Furthermore, the proposed disclosure requirements should be rationalised and improved. 4
Given the seriousness of the concerns that we have raised, we recommend that a robust consultation and consideration of alternative proposals is undertaken before any new accounting model is finalised. We would welcome the opportunity to discuss any aspects of the matters raised in this letter. Yours faithfully Paul Fearn Group Director of Finance & Control Tesco PLC 5
scope 2013-270 APPENDIX A. Flaws in Type B model The Type 13 model in particular contains a number of conceptual flaws and inconsistencies with existing IFRS requirements. We believe this to be an inevitable consequence of the attempt to resolve the Income Statement issues in the ED/2010/9 by forcing leases which are non-financing in nature onto the balance sheet. The primary flaws that we see in the Type B model are summarised below: Inconsistencies between balance sheet, income statement and cash flow treatment 1) Whilst the proposals recognise Type B leases on balance sheet, the income statement and cash flow treatment will be similar to that of operating leases under the existing requirements of las 17. This means that for balance sheet purposes, Type B leases will be accounted for as if they are financing in nature, however for income statement and cash flow they will be accounted for as operating arrangements. This inconsistent treatment will lead to meaningless financial ratios, including for example the existence of debt for which no financing charges exist and for which all associated cash flows are treated as operating cash flows. Measurement - Amortisation of right-of-use assets 2) For Type B leases, the amortisation of right-of-use assets will be determined as the difference between the straight line periodic lease cost and the unwinding of the lease liability. This approach will give rise to a balance sheet amortisation charge which increases annually over the life of the asset. This back loaded amortisation approach is very unlikely to reflect the pattern of consumption of the underlying asset by the lessee and as such is inconsistent with the requirements of las 16. In addition, this amortisation method will lead to a meaningless net book value for the lessee and may therefore lead to inappropriate impairment in early years due to back loading of amortisation charges Measurement of measurement 3) Even where all relevant line items are considered, the measurement of right-of-use assets and lease liabilities under the proposals will also introduce confusion for users. The proposed measurement basis includes certain cash flows such as variable lease payments dependent upon an index or rate and the extension options and purchase options where a significant economic incentive to take such options exists. However, the measurement basis excludes other costs such as cash flows in respect of variable lease payments. 4) In addition, the measurement is based on different on lease terms which are i) driven by lesseets commercial requirements, ii) dependent on the asset owner for the underlying assets; iii) dependent on country specific leasing environment (some countries prefer short term leases); and iv) dependent on the timing of renewal of existing leases. As these various factors affect the measurement, values on the balance sheet may give false comfort to readers who believe that the balance sheet position reflects a complete picture of leasing arrangements. Volatility Ts business objectives 5) There will be an annual re-measurement of lease liabilities and right-of-use assets under the proposals for factors such as changes in indices. 6
6) Additional unnecessary volatility will also result from recognising significant new leases when existing leases expire. These re-measurements will introduce confusion for readers and compromise the year-on-year comparability of financial statements Itnpairtnent of assets and goodwill 7) las 36 requires the carrying amount of a cash generating unit (CGU) to be compared to its recoverable amount. Carrying amount will include the net book value of any right-of tise assets. It is not clear how these elements of the proposed model could be consistently included within the assessment of recoverable amount: For the value-in-use model under las 36, it is not clear whether forecast cash flows should include lease payments after the end of the lease term. If such payments are not included, this will not fairly reflect the long term cash outflows of the business if the lease is likely to be replaced or renewed; [AS 36 Impairment of Assets does not allow forecasting beyond five years as forecasts beyond this period are considered to be tinreliable. I-low does this requirement reconcile to the above point on leases longer than five years in duration; It is not clear how the Ihir value option for recoverable amount under las 36 should be used for a right-of-use model which i) does not represent the full term of the asset life and ii) does not represent the full value of the asset as it does not include variable payments. 8) An impairment assessment tinder las 36 requires the net book value of assets to be compared to their recoverable amount. For right-of-use assets under a Type B lease, the determination ol this net book value includes a balancing figure for each amortisation charge, being the difference between the straight line periodic lease cost on the asset and the unwinding of discounting on the associated lease liability. This meaningless net book value may lead to a meaningless impairment result during the early years of the lease as the amortisation charge is back loaded. 9) Right-of-use assets will be measured on inception using a discount rate equal to the rate the lessor charges the lessee or the lessee incremental borrowing rate. 1-lowever, impairment tests (value in use option) tinder las 36 will be performed based on future prevailing interest rates. This inconsistency could lead to incorrect impairment results - either inappropriate impairment (interest rates increase post recognition) or masking of impairment requirements (interest rates decrease post recognition).. Inconsistencies between lessee and lessor accounting 10) An asset under a Type B lease will appear on two balance sheets and, in many cases, the total value of the right-of-tise asset on the lessee s balance sheet and the underlying asset on the lessor s balance sheet will be higher than the fair value of the underlying asset. 11) For leased assets within a group of companies, this means that an asset subject to a Type B lease will be in two group balance sheets, being amortised at different rates, It also means that the lessee will have a lease liability but the lessor will have no corresponding receivable. This will give rise to group inconsistencies and significant challenges on the elimination of intergroup leases on consolidation. In addition, where a Type 13 lease is in place between a joint venture and one of its venturers, the consolidated accounts of the venturer will show both a ROU asset and a share of inestment in the JV. 7
B. Conceptual flaws inconsistency with conceptual framework and other standards Amendments from ED/2010/9, whilst dealing with some of the flaws in that Exposure Draft, do not address the underlying conceptual problems with the proposals and thus bring in a set of new accounting inconsistencies. These are summarised below: Recognition Measurement 12) Under the current proposals, a lessee is required to recognise a liability and a corresponding right-of-use asset on entering into a lease. However, all lease agreements require the counterparties to fulfil their respective obligations throughout the duration of the lease. As such, we do not believe that a liability or asset can be recognised when applying the relevant definitions under the conceptual framework. 13) In the case of the lessee s liability, there is no past event on inception as the lessor only fulfils their obligations during the lease term. In the case of the lessee s asset, it is clear that an asset does not exist as the lessee s rights to the asset is not fully met until payments have been made. 14) In addition, the recognition of liabilities in relation to lease contracts would be inconsistent with other forms of executory contracts such as capital commitments, service agreements and agreements to buy inventories in the future, which are not allowed to be recognised as liabilities on the balance sheet. Lease liabilities and right-of-use assets 15) The measurement of lease liabilities and right-of-use assets will include payments made by the lessee over the period covered by an extension option where there is a significant economic incentive to take the option. This is inconsistent with las 32 which requires a contractual obligation to exist in order for a financial liability to be recognised and also inconsistent with las 37 that requires present obligation to exist before recognising a liability. 16) Further to the above point, the inclusion of extension periods in the measurement of liabilities and assets is inconsistent with the conceptual framework in that there is no past event giving rise to the liability until the extension option is taken. In the absence of a past event the definition of a liability under the conceptual framework is not satisfied. 1 7) Although the concept around extension options is also in the current lease standard, this proposal has more significance as the measurement of these option will be recorded on the balance sheet 18) Lease liabilities will be re-measured each year for changes in various factors, including changes in indices such as Retail Price Index (RPI). Most of these re-measurements will also affect right-of-use assets. This will give rise to asset volatility for indices such as RPI. The volatility in the balance sheet and income statement that does not have commercial substance as the lease assets and liabilities have not fundamentally changed since inception. The re-measurements will impact financial ratios, thus reducing understandability for users of the financial statements. 8
9 21) On an on-going basis, substantial costs will arise relating to the requirement to monitor 22) The proposals increase complexity by increasing the number of leasing models from two Increased complexity D. Other concerns 20) In addition, systems may be unable to support concepts that are not based on commercial 19) On implementation, there will be significant costs associated with data capture and significant cost involved in implementing them. systems development. effectively a balancing figure between the straight line income statement charge and the C. Significant costs of proposals For companies with a significant number of leases, the current proposals will give rise to a significant not appear to be sufficient benefits to be gained from the proposed accounting changes to warrant the and re-measure lease liabilities and right-of-use assets each year. En addition, it is likely cost and resource burden, both on implementation and on an on-going basis. In our view, there does substance. Examples are: i) amortisation of right-of-use assets for Type B leases which is unwinding of the lease liability; and ii) annual re-measurement of lease liabilities and right-of-use assets. Such proposals will be challenging to integrate into existing systems Under the current proposals, this is likely to require the maintenance of two separate systems to record lease accounting data. which are designed around the underlying concepts of existing IFRS. that companies will be required to maintain a separate set of records for tax purposes. tinder the existing lease standard to three tinder the new proposals - short term leases. Users of the financial statements will therefore need to look at the measurement of lease liabilities. additional multiple line items, including understanding the new unconventional Type B Behaviour change companies making leasing decisions which are not in the best interests of users. For 23) Presenting all lease contracts as though they are financing in nature may lead to accounting, in order to gain a complete picture of the leasing arrangements of an organisation. example, companies may have an incentive to arrange one year leases that can be classified as short term under the proposals in order to avoid creating misleading net debt figures on the balance sheet. The operational uncertainty and costs associated with annual renewals in such a circumstance is unlikely to be in the best interests of shareholders. Similarly, companies may be incentivised to negotiate a maximum level of variable payments in their lease contracts because such payments are outside the scope of A, Type B and Type 2013-270