Industry-specific guidance is needed in the retail and consumer sector
Will your competitors have the same understanding of IFRS
The IFRS 2005 transition process necessitates the clarification and harmonisation of accounting principles not only across geographies but also within industries. One of the risks that companies in the sector may run is inconsistent applications of the standards. There needs to be a common understanding of the impact of IFRS on the retail and consumer sector as a whole, even though underlying corporate economics will not have changed.
In general, the greater comparability of financial information under IFRS is likely to lead to more probing questions from analysts and other investors, because the differences between companies will become much more transparent. Management will need to ensure that it has sound explanations for significant variations between its own corporate information and that of its industry peers.
The retail and consumer sector should be encouraged to adopt a common vision of sensitive, industry-specific issues
The recent reporting irregularities highlighted in the financial results of such companies as Ahold or Parmalat serve to underline the importance for retail and consumer multinationals to engage as early as possible into IFRS transition. This transition needs to be embedded in other major processes within the organisation, thereby contributing to the improved efficiency of internal control and corporate governance in general.
IFRS is a principles-based standard built around certain precepts, such as "substance over form".
As local GAAPs and existing industry practices do not always coincide with current IFRS guidance, the consequences of IFRS requirements need to be analysed and applied for certain industry-specific issues. Retail and consumer companies need to address their transition issues with future reporting strategies in mind.
Revenue recognition is at the heart of any accounting standards and continues to create difficulties for both the people who use and prepare corporate accounts.
The application of IAS 18 (revenue recognition) could in some cases lead to a reduction in sales, or to the recognition of sales at a later date. A reduction in a company’s sales for "accounting changes" is likely to be treated with cynicism by analysts and stockholders. It is therefore essential for a company to explain the principles used in terms of revenue recognition with transparency.
IAS 18 may not provide guidance for all detailed transactions one could meet in the industry. As a consequence, each specific transaction needs to be analysed in compliance with revenue recognition principles. This is of particular concern in complex transactions such as those combining services and goods.
Certain specific-industry issues related to the retail and consumer sector need careful study, for instance: returns from customers, "trade loading", concessions in department stores, "bill and hold" transactions, warranty, combined sale of goods and installation, and franchise sales and royalty income. Concrete examples of the first three of these issues follow.
Returns from customers
A common practice among the retail industry is to accept returns from customers. Let’s take an example of a retail store where customers can return products within one month of the date of purchase. So, when customers return an expected 10 % of the retailer’s sales, management should recognise revenue on the sale of the goods, with a 10 % adjustment to revenue (through the recording of a provision) to reflect the risk of returns. The recognition of revenue and the provision for returns should be booked when the sale is made.
"Trade Loading"
"Trade loading" is a practice that can be used to boost year-end sales through the retailer’s purchase of much more inventory than is actually needed. It can also include the granting of special concessions by the supplier to the retailer such as relaxed return policies, extended credit terms and side agreements. This type of concession can have an impact on the appropriate recognition of the sale and creates a significant risk of return for the supplier, as revenue cannot be reliably measured. Revenue linked to this kind of agreement should not be recognised at year-end ; the difficulty resides in capturing these practices.
Corners in department stores / Concession agreements
Retailers, and in particular department stores, frequently operate an element of their business on a "store-in-store" or concessionary basis. The level of sales generated by concessions varies significantly amongst department stores from below 20% to 50% or more. In practice, many department stores in the world currently recognise the gross value of sales made by concessions in their aggregate sales figures.
According to IAS 18, most concessions in department stores would be reclassified as agent operations. As a consequence, only the commission receivable should be recognised within sales.
Even if a department store needs to recognise only commission, it will be possible for it to disclose the gross sales handled by concessions in the notes to its financial statements.
Accounting treatment of vendor rebates and allowances is often linked to existing local practices. Comparability on this key factor is a strategic issue for most companies in the retail and consumer sector.
Retailers receive allowances from vendors through a variety of programmes and arrangements.
Given the highly promotional nature of the retail and consumer industry, the allowances are generally intended to help defray the costs of promoting, advertising and selling the vendor’s products in a retailer’s store. Examples of such arrangements include volume rebates, advertising contributions, promotional discounts, contributions to store fittings, store opening discounts, salary support and slotting, stocking and display allowances.
These allowances raise the issue of revenue recognition for retailers, and of cost allocation for consumer companies. Management’s aim should be to reflect the economic substance of the arrangements. Based on the substance of transactions and IAS 18 principles, three criteria should be considered to determine the classification of vendor allowances:
- is there an identifiable benefit to the vendor?
- are services provided separable from the purchases?
- is the service billed at fair value?
Based on industry practices, many vendor allowances will not meet these three criteria and be reclassified in reduction of cost of goods sold in retailers’ financial statements.
The recording of the transaction on the consumer company’s side should ordinarily mirror the retail company’s recording treatment: as a reduction of revenue - or less frequently - as an expense.
Impact on inventories should also be considered
If most vendor incentives are reclassified in reduction of cost of sales, this accounting treatment will have important consequences on the valuation of inventories in retail companies, in accordance with IAS 2. Since the cost of acquiring goods will decrease, the cost of inventories will also decrease, resulting in a significant impact on the income statement of retailers.
Promotion and advertising expenditures
Consumer companies have substantial promotions and advertising expenditure. These expenses cover many media channels: TV, radio, print, sponsorship, Internet and mobile telephone networks
IFRS (IAS 38 on intangible assets and the conceptual framework for IFRS) does not offer prescriptive guidance on how to classify this expenditure. However, management needs to consider the most appropriate allocation of these costs within the income statement.
These costs may appear in several categories: cost of sales, reduction in revenue, marketing and selling, general and administration. The date of recognition and/or the period over which to spread these costs are also important points to consider. It may be that certain costs are split, with a portion going through the income statement and a portion being deferred. For example, the cost of a television commercial includes the cost of production (which may be deferred in some limited circumstances) and of broadcast (which is likely to be expensed when incurred).
Coupons/gifts and loyalty cards
The determination of the liabilities linked with these programmes and the way they are presented on the income statement needs to be reviewed in order to reach compliance with IFRS. For example:
A clothing retailer has launched a new promotional campaign. It publishes a coupon in a national newspaper giving a discount of 5% off any purchase over 50€ in any of the retailer’s stores. In this situation, the retailer should not recognise the distribution of coupons in its financial statements. The retailer should treat the coupon as a discount against revenue when it is redeemed by the customer. The coupon is considered as an encouragement for customers to spend, rather than being seen as a cost of promoting the stores. The cost of the advertisement in the newspaper should be expensed when the newspaper is published.
Management should not recognise any provision when distributing the coupons. It should treat the coupons as a cost of sales when customers redeem them. The coupon encourages customers to make purchases and thus leads to revenue generation.
Amongst the areas relating to reporting policies, the following two topics are particularly specific to the industry.
Segmental reporting
Retail and consumer companies will find the disclosure of segmental information something of a challenge. According to IAS 14, entities are required to disclose both geographical and business segment information, based on similar risks and rewards.
Management will have to assess how best to group these business segments. Retailers and consumer companies will need to analyse what their primary reporting segment will be and how to disclose information according to store format and region (contry, continent,..).
These disclosures will highlight sensitive information to competitors and other users of the financial statements that would previously have been private.
Presentation of the income statement
In some countries, retail and consumer companies report their income statement by nature of expense today. IAS 1 (presentation of financial statements) allows for presentation by nature of expense or by function. Most companies will certainly move towards presentation by function, as the future rule related to "performance reporting" which is currently under review by the IASB, will authorize only this type of presentation. As a consequence, retail and consumer companies that are planning substantial changes in their information systems, should be encouraged to initiate a presentation of their income statement by function, and to prepare analysts and stockholders for this new format.
Property and leases represent an important reporting component for retail and consumer companies. The following topics are particularly relevant to the retail and consumer industries.
Rent-free periods and reverse premiums
Retail companies often enter into lease contracts obtaining a rent-free period of one year. Under IAS 17 (leasing) and the conceptual framework, the company should record a rental expense for the first year, thereby reflecting economic reality.
Based on the matching of rent-free periods to the full lease period there will no longer be a difference between a low rent throughout the entire lease period and a rent-free period up front. However, from a cash flow perspective, the use of rent-free periods remains attractive.
Classification of a lease as a finance lease or an operating lease
Many retail and consumer companies use finance leases for their buildings and stores. The classification of these leases under IAS 17 could be different from current practices. In particular, the example of sale/leaseback transactions can be very complex to assess. For instance, if a retailer enters into a leaseback transaction for a warehouse, which has been customised for its own activity, the lease is likely to be qualified as a finance lease.
All lease contracts need to be assessed based on facts and circumstances in order to determine the accounting classification in accordance with IAS 17.
Both the elaboration of capitalisation policies and the fixing of depreciation lives for fixed assets require careful analysis of the facts in line with the principles (IAS 38 – intangible assets) and the prevailing business environment.
"Key money"
Retailers often pay premiums to a previous tenant or to the owner of the premises in order to obtain prime leasehold premises. These payments, commonly known as "key money", can take several forms, including payment to existing leaseholders to exit the lease or payment of a nonrefundable deposit on the commencement of the lease. According to IAS 17 (leasing), management should defer the payment of key money over the period of the contract, as the key money represents a prepayment of a rent.
Pre-opening costs
Pre-opening costs often include rents or other expenses incurred before opening the store. Generally, these costs will not satisfy the capitalisation criteria and will need to be expensed as incurred.
Finding a satisfactory way to report on intangibles (IAS 38), such as brand trust, constitutes one of the big reporting challenges of the future. Corporate reputation can takes years to build but is not reflected satisfactorily in today’s reporting framework.
Brands
Many retail and consumer companies have intangible assets in brand names that they have built up over the years, through acquisitions and mergers. Key points to consider are the valuation of these intangibles, annual impairment reviews and the allocation of valuation of these assets to business segments, in compliance with IAS 38 (intangible assets).
According to IAS 38, most costs related to brands are expensed as incurred, such as internally generated brands or costs related to brand deposit. As a consequence, only brands valued through acquisitions and mergers can be recognized in the balance sheet.
As far as depreciation is concerned, current rules require depreciating intangible assets (including brands) over a maximum period of 20 years. IAS 38 is currently under review (as part of Business Combination exposure draft): one of the major changes anticipated in the future rule is the possibility to have brands with indefinite lives, which means they are not amortized. In this latter situation, an impairment test is performed annually, according to IAS 36.
Guidance to make the split between definite and indefinite brands needs to be reviewed in line with new rules to be issued.
Some very specific issues are linked to inventory valuation in the retail and consumer industry, as for example:
Accounting for shrinkage
A retailer experiences shrinkage mainly through theft, breakage or other loss. Experience shows that approximately 0.5% of all shelved stock is subject to shrinkage. Shrinkage, whether measured through stocktaking or estimated by management, should be accounted for as cost of sales. Management should measure inventories based on the actual quantities, which should be reduced to reflect any shrinkage that has occurred since the last stock-take.
IAS 36 (impairment) requires determining impairment of tangible and intangible assets based on CGU (cash generating units).
In order to determine impairment of assets, the relevant cashgenerating unit (CGU) could be in the retail sector - an individual store or a chain of stores.
In most situations, the store meets the definition of a separate cash-generating unit. This issue will need to be re-analysed in line with the new rules for impairment and especially the impairment rules for goodwill (as part of Business Combination exposure draft).
Derivative transactions have received significant attention in recent years, with new accounting standards being published recently. These transactions range from being very simple to extremely complex.
The implementation of financial instruments rules (IAS 32 and IAS 39) constitutes a challenge for companies in the retail and consumer sector - as it does for companies in other industries. A specific issue for retail & consumer companies is described hereafter.
Commodity hedging
Food companies can enter into forward contracts for the purchase of commodity products such as cocoa and coffee and for the purpose of managing the price fluctuation risk on their purchases of raw materials. To obtain hedge accounting on this type of transaction, IAS 39 requires stringent conditions to be met, and specifically that prospective and retrospective hedge effectiveness tests be successfully performed.
Unfortunately, hedge effectiveness tests for commodity contracts are usually complex and difficult to perform, as there is often a difference between the hedged item and the hedging derivative, in such factors as product quality, location and date of delivery. This situation can imply price discrepancies that can lead to failure in the effectiveness test.
In this respect, most hedging operations could be re-qualified. As a consequence, companies will have to mark these operations to market in their financial statements, creating additional volatility.
What effect will the implementation of IFRS have on companies' relationships with investors and financial analysts
The above examples of some of the issues confronting retail and consumer companies reporting under IFRS are not exhaustive, and there are more to come. Given the pace of developments, it is critical that companies devote sufficient resources to the implementation of the new standards, in order to be prepared to face the challenges ahead.
A better assimilation of the new standards can be achieved by the early communication of transition plans and the drawing up of an impact assessment well in advance of the publication of the first IFRS financial statements. There may be increased volatility of earnings as well as changes to the recognition of income and expenses under IFRS, but the new standards will have no effect on cash flows and key non-financial metrics. We are encouraging companies to take early measurements of the impact of IFRS on their key indicators and to adapt corporate communication to reflect these new challenges.
Adoption of International Financial Reporting Standards (IFRS) will change more than just the contents of financial statements. Companies, regulators, creditors, investors and financial analysts all face the challenge of adapting already overburdened reporting systems and processes to contend with the changes that IFRS demands.
Defining IFRS data requirements, documenting them and integrating them into accounting and other business systems throughout the group for consolidation purposes will be a challenge. For regulators and analysts, making full use of the data that will become available represents another challenge. Fortunately a new technology, XBRL – eXtensible Business Reporting Language – will facilitate the process of communication, which underpins a successful transition.
But perhaps most importantly, retail and consumer companies must understand the effect the new accounting standards can have on brand value and effectiveness, and embed this knowledge into their business practices.
