05 July 2019 by John Stittle
Retail stores hit by reporting impairments
The stormy financial headwinds continue to decimate British high streets. Many business sectors have been affected, including banks, travel agents, estate agents, fashion clothing shops and, certainly not least, long established departmental retail outlets. The online retail revolution is, directly or indirectly, hitting most of these business sectors. But over the last few years, it’s the retail chain stores that have been particularly affected.
The list of leading high street retail casualties continues to lengthen: BHS, Toys R Us, House of Fraser, Mothercare, HMV and now, Debenhams. In many cases, the trading distress of retail companies is evidenced by the increasing application of asset impairments (write-downs) being recognised in financial statements. Some of the assets requiring impairment often include intangible items such as goodwill, property and onerous leases.
The impairment reporting rules, contained in IAS36, Impairment of Assets, is the reporting framework that most companies are required to adopt in their financial statements. However, many of these international accounting rules are not always straight forward to implement in a practical or ‘real-life’ context. Frequently, IAS36 requires companies to make significant and uncertain estimates, make difficult judgements and often construct precarious cash flow projections – all of which can significantly impact on the amount of impairments being recognised in the accounts. But is determining the level of many impairments often little more than just calculated guess work?
This April, Debenhams, a former High Street stalwart, became another victim of the retail revolution and entered into a ‘pre-pack’ Administration after a last minute failed rescue attempt by Sports Direct. The effect of the ‘pre-pack’ was that shareholders were wiped out and negotiations were started to restructure its debts, close stores and reduce the company’s lease rentals through a Creditors Voluntary Arrangement.
Debenhams’ failings - as with other distressed ‘bricks and mortar’ retailers, have largely stemmed from falling sales, excessive debt, expensive maintenance of property portfolios and inescapable onerous store rentals. Many have failed to fully embrace more imaginative retailing methods, for example, often having a weak, restricted and poor-quality on-line sales base. Indeed, Debenhams’ most recent financial statements typify many of these challenges facing retailers today.
Debenhams’ year-end financial statements issued last autumn before entering Administration, highlighted the bleak performance of the ailing retail group with reported operating losses being a disastrous £481.3m. But this reported loss has partly arisen from exceptional items in the accounts resulting from restructuring costs, high debt servicing, impairments and onerous lease costs.
Significantly, the group has recognised a whopping £524.7m pre-tax hit for exceptional items in its income statement. If these exceptional items are then dissected, it is apparent that the majority of the charges-419.6m-relate to costs for impairments and onerous leases; and the remaining balancees attributed to other asset write-offs and restructuring.
In particular, the notes to the financial statements further point out that the ‘material’ non-cash impairment for goodwill amounted to £302.1m – which is considered ‘significant in value’ to the Group’s results and ‘reflect a change in the direction of the outlook of the business’. Perhaps rather an understatement considering that Administration followed shortly after these results were announced.
The rules relating to impairments used by Debenhams and other companies are not as objective or reliable as some users of financial statements often believe. IAS36 applies mainly to land and buildings, plant, equipment, intangible assets including goodwill and investments in subsidiaries.
Every year, companies are required to evaluate whether there are any indications that an asset may have suffered an impairment. IAS36 suggests that both external and internal sources of possible impairment should be examined.
The external factors that may indicate impairment include changes in markets, technology or in the economy; and internal sources may include obsolescence or damage to assets and under-performance of investments in subsidiaries. But for some assets an impairment test is often conducted annually - irrespective of whether there is any evidence. This category includes such items as goodwill arising upon consolidation and intangible assets with an indefinite life.
The key objective of IAS36 is to ensure that assets are not carried in a company’s balance sheet in excess of their recoverable amount (RA). The RA is defined as the higher of fair value (FV) and economic value (EV) – often also called ‘value in use’.
But firstly, the definitions: FV is defined more fully in IFRS13, Fair Value Measurement. FV is largely regarded as the price that would be paid for the asset in the open market. EV is the present value of the future net cash flows expected from using the asset.
For example, if Company A is carrying an asset at £100 in its balance sheet, the assets at fair value (FV) are £80, and its EV is £85; then its recoverable amount is £85 (the higher of FV or EV). So the asset is being recognised in the balance sheet at £100 - when its RA is only £85. As a result, IAS36 requires the difference of £15 to be written off as an impairment loss in the income statement and the asset also correspondingly reduced in the balance sheet.
In practice, fair values of assets are not always easy to determine. But the area that frequently causes companies (and later for their auditors) the most challenges is how to calculate the EV.
The accounting regulations require companies to estimate the future cash flows that are expected to arise from using an asset; then take account of possible variations in the amounts and timings of the cash flows; and finally apply a discount factor based on the current market risk-free rate of interest in order to find the present value.
Then,to further add to the complexity and uncertainty, IAS36 requires the estimates of the cash flows to be based on ‘reasonable and supportable assumptions.’ Normally, these cash flow projections should not exceed five years – although the rules allow companies to exceed this level, but the cash flows would then need to be extrapolated from earlier budgets. So, there is plenty of scope for individual judgement and estimates here.
Even the discount rate is subject to considerable discretion. The rules require that in determining the EV, the future cash flows are discounted at the pre-tax rate which reflects the market assessment of the time value of these cash flows and the risks inherent in the underlying asset.
In summary, IAS36 then states that the rate should equal the rate of return that investors would normally require if they were investing in another asset that would be expected to generate equivalent cash flows.
Debenhams has decided to use a 7.2% discount rate which it believes reflects specific risks in the retail business. But even small variations in this rate can have quite significant implications. The sensitivity analysis in the notes reveals that a mere 0.5% variation either way in this discount factor may affect the impairment charge by around £48m; certainly not an inconsiderable amount within the context of the currently reported level of impairments.
Overall, increasing numbers of retail chain stores are reporting impairments in the financial statements. This is perhaps unsurprising, considering the pressure that online trading disrupters are exerting on the traditional and costly ‘bricks and mortar’ retail model. But the nature of IAS36 often gives companies generous scope in determining the recoverable amounts of assets in general and of the economic values in particular. Users of financial statements should be aware that these impairment tests are frequently just approximate indicators – not always precise write-off numbers.
John Stittle is a Senior Lecturer at University of Essex