In an earlier note, I highlighted the nearly £4bn of off-balance-sheet property bonds that are not fully disclosed in Tesco’s financial statements (see Tesco’s hidden debt). In the earlier note, I discussed in detail how the transactions were structured. In this note, I focus on the relevant accounting issues; in particular, whether the underlying leases were correctly accounted for as operating leases. In my view, it is clear that they should have been treated as finance leases and capitalised on Tesco’s balance sheet, which would increase on-balance-sheet net debt by around £3.5bn to £11bn.
Between 2009 and 2013, as part of its sale and leaseback programme, Tesco used off-balance-sheet special purpose vehicles (SPVs) to issue a series of credit-linked CMBSs, the proceeds from which were used to finance the acquisition of various properties from the company. The properties were bought by joint ventures between Tesco and third party investors, and leased back to the company for 30 years. The bonds will be fully repaid by the end of the leases from the rent paid by Tesco. As the company, in effect, guarantees their repayment, the bonds have the same credit rating and are viewed as equivalent to Tesco’s corporate bonds. A more detailed description of how the transactions were structured is given in my earlier note.
The classification of the leases as operating leases has a number of major presentational benefits. First, the bonds remain completely off-balance sheet. Second, the properties sold and leased back were removed from Tesco’s balance sheet, reducing capital employed and increasing return on capital. Third, Tesco immediately booked profits on properties sold for more than their book value, which it included in underlying profits, as property development was then seen as an integral part of its strategy. It is also worth noting that the main metrics used by the company for assessing management bonuses were return on capital and earnings growth.
Under IFRS, leases are classified as either operating leases or finance leases. In simple terms, a finance lease is recorded as an asset on the balance sheet with an offsetting debt liability, whereas an operating lease is not included on the balance sheet, although future minimum lease payments must be disclosed in the notes. The two are also treated differently in the profit and loss statement: rent on operating leases is charged as an operating expense; finance leases include both an interest expense and a depreciation charge.
All leases are, in effect, a form of financing; the rental payments represent a financial commitment similar to debt. Many analysts, including the rating agencies, include the present value of future operating lease payments in their calculations of total debt. However, under IFRS (see IAS 17), finance leases have a specific definition: a lease is a finance lease if it transfers substantially all the risks and rewards of ownership. All other leases are operating leases. For finance leases:
“the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its economic life in return for entering into an obligation to pay for that right an amount approximating, at the inception of the lease, the fair value of the asset and the related finance charge.”
IAS 17 lists examples of situations that would normally result in a lease being viewed as a finance lease, although ultimately the classification depends on the substance of the transaction. Nonetheless, companies and auditors seem to use the examples given as a checklist for classification.
Sale and leasebacks
The same test applies to assets that have been sold and leased back. Tesco has regularly raised cash to finance new investment through the sale and leaseback of stores and other properties. In earlier transactions, it typically sold properties to a joint venture formed with a property company; leasing the properties back for a term of 20–25 years, with options at the end of the lease to buy back the properties at market value or renew the lease at market rents. Treating these leases as operating leases is less controversial. While invariably financed largely by debt, fundamentally they are arms-length-negotiated property transactions, where the purchase price is a reasonable estimate of market value.
The property bond-financed sale and leasebacks pushed the boundaries considerably, although Tesco sought to portray them as normal sale and leasebacks,. The following is the description in the 2013 annual report (Note 28 Related party transactions) of the most recent transaction (Tesco Property Finance 6):
“On 13 February 2013, the Group completed a new sale and leaseback transaction involving UK property assets, structured as a 50–50 joint venture with the Cambridge University Endowment Fund. Four trading stores and three mixed use sites under development were sold for a total consideration of £493m.”
The property bonds are not mentioned in this note or the rest of the annual report, remaining hidden behind the joint venture. No explanation is given for treating the leases as operating rather than finance leases. However, it is clear that fundamentally these are financing transactions: substantially all the risks and rewards of ownership continue to be borne by Tesco; therefore, the leases should have been classified as finance leases.
One of the examples listed in IAS 17 of situations that would normally result in classification as a finance lease, is where the present value of the minimum lease payments is substantially all the fair value of the leased assets. As the bonds will be completely repaid by rent paid over the 30-year lease term, the issue proceeds were equal to the present value of the lease payments, discounted at the bond interest rate. Furthermore, the properties’ purchase price was based on the bond issue proceeds. Therefore, assuming this approximated the properties’ fair value, the leases should have been classified as finance leases. As Figure 1 shows, the issue proceeds were actually higher than the independently assessed market values in five of the six transactions.
Figure 1: property bond transactions
Source: Tesco annual reports, bond prospectuses
Two counter-arguments could be made; both of which depend on the definition of minimum lease payments in IAS 17. First, Tesco is able to terminate the leases after 10 years; so only lease payments during the first 10 years should be included in the present value calculation. However, to end the lease, Tesco must first exercise an option to buy back the properties at market value and fully repay the bonds. It would therefore be absurd to argue that the company does not bear the risks and rewards of ownership because of the early termination clause. Second, even if lease payments over the full 30 years are included in the present value calculation, increases in rent due to index linking should be ignored, because contingent rent is excluded from the definition of minimum lease payments. The flat lease payments discounted at Tesco’s incremental borrowing cost would not amount to substantially all the properties’ value. However, to assess the substance of transaction, the entire transaction should be considered, not just the lease. To ensure that the bonds will be repaid, Tesco has entered into swap arrangements, converting the uncertain, index-linked rent into a fixed repayment schedule. Perhaps, a simpler way of reaching the same conclusion would to use a lower, real discount rate, rather than the nominal borrowing rate.
What is the substance of the transactions?
Considering the issue in a rules-based way like this, inevitably leads to arguments based on the form of the transactions. Several other factors, however, clearly show that in substance these were financing transactions.
First, through the lease payments and swap arrangements, Tesco is contractually obliged to repay the bonds. The main issue for bond investors was Tesco’s credit rating, not the value of the underlying properties. Taken to its logical conclusion, a company could use this transaction structure to avoid recording debt on its balance sheet by selling and leasing back an asset of nominal value.
Second, the amounts received by Tesco for the properties appear to have been based on the bond issue proceeds, rather than the fair value of the properties negotiated on an arms-length basis. The issue proceeds depended on the bond interest rate, which was linked to Tesco’s cost of borrowing, not the value of the properties. In the four most recent transactions, the sale proceeds reported by Tesco were equal to the issue proceeds. For the first two transactions, while not entirely clear, it appears that the proceeds reported by Tesco are lower because of the repayment of existing loans.
Third, the involvement of third party investors was not essential to the transactions. In some of them, including those with Tesco’s own pension fund, the investor had an interest in the partnership prior to the bond issue, but this was not always the case. For example, the prospectus for Tesco Property Finance 5 states:
“It is anticipated that at some point following the sale of the Bonds on the Closing Date, [Tesco] will sell (although it is not required to) half of its interest in the Partnership to a third party investor”
It would be interesting to know how much the third party investors paid for their interests, although this is not disclosed. Given the high degree of uncertainty about the value of the properties at the end of the 30-year leases, I suspect that the amounts paid were relatively small.
Fourth, the three transactions with its own pension fund involved no transfer of risk from Tesco’s balance sheet. Legally, the pension fund may be separate, but not from an accounting perspective: the net pension liability is included on Tesco’s balance sheet. By selling property interests to its pension fund, the company is merely shifting risks from one part of its balance sheet to another: ultimately Tesco still bears the risk of a fall in the properties’ value.
Finally, Tesco continues to bear all day-to-day risks relating to the properties, including repair and insurance.
True and fair override
The UK’s Financial Reporting Council (FRC) recently confirmed the “fundamental importance” that a company’s financial statements give a “true and fair” view. Ultimately, in the event of a conflict, this would override specific accounting rules. Furthermore:
“the preparation of financial statements cannot be reduced to a mechanistic following of the relevant accounting standards. Objective professional judgment must be applied to ensure that financial statements give a true and fair view.”
The FRC made clear that it would be difficult to present a true and fair view if form had overridden substance. Companies should not attempt to exploit loopholes in accounting rules based on purely technical arguments. Under UK law, both the company’s directors and auditors must confirm that the financial statements give a true and fair view.
The classification of the leases as operating leases enabled Tesco to immediately recognise profits on properties sold for more than their book value. The profits on individual transactions were not disclosed, but during the four-year period when the transactions occurred, Tesco earned total property-related profits of around £1.6bn. If the leases had been classified as finance leases, any profits would be recognised over the term of the lease. This means that earnings during the period 2010–2013 were significantly overstated by the early recognition of profits on the property sales.
The arguments raised in this note may appear arcane and technical. Unfortunately, this is unavoidable given the transaction structure used. The inherent complexity enables Tesco to obfuscate the issue. An accounting sleight of hand means that the transactions are presented to shareholders and other users of the accounts as normal sale and operating leasebacks, while the property bonds were marketed to potential investors as equivalent to Tesco corporate credit. In my view, the bonds should be viewed as debt obligations of Tesco and recorded as such, rather than hidden off-balance sheet. Classifying the leases as finance leases would add around £3.5bn to Tesco’s on-balance-sheet debt.