Beware the IFRS 16 inflation headwind – Tesco

The capitalised lease liability of an inflation-linked lease does not include expected inflation. This results in a lower liability and lower initial expense compared with an equivalent lease with no inflation link. The IFRS 16 figures are updated as the inflation uplift occurs, but these catch-up adjustments create a profit ‘headwind’.

We estimate that Tesco’s inflation-linked leases result in a pre-tax profit headwind of about 2.2 percentage points of growth.  If inflation were included in the measurement of the lease liability instead, we estimate it would increase from the reported £10.3bn to approximately £15.2bn.


You should take particular care to identify if lease obligations are inflation linked, especially where those leases are long-term. Under both IFRS and US GAAP the lease liability and right-of-use asset, when initially measured, do not include expected inflation. The IFRS 16 lease liability is subsequently remeasured each period when lease payments are updated for the change in the inflation index. Remeasuring the liability increases the carrying value of the right of use asset, producing a rising depreciation expense and an operating profit headwind.

The lease interest expense is also impacted due to the additional liability amount. For leases with fixed payments (including fixed increases in payments) interest falls as the liability is repaid. For inflation-linked leases this fall is offset by new interest expense. The headwind effect on pre-tax profit and net income includes both the additional depreciation and additional interest arising from the inflation uplift in the period.

Depreciation and interest profile for an inflation linked lease
These charts illustrate the profile for depreciation and interest over the term of a 30-year lease, with initial lease payments of 1,000 that are either unchanged in future periods or increase with inflation. The discount rate is 5.8% and the inflation assumption is 3% p.a.

The increase in the right of use asset is, in effect, additional capital expenditure. However, unlike other additions to fixed assets, whether due to asset purchases or new leases, there is no actual increase in productive capacity. In our example above, the capital expenditure on initial recognition of the lease is 14,262, being the present value of annual payments of 1,000 discounted over 30 years at 5.8%. If there is no inflation uplift to lease payments this is the only addition to fixed assets. However, an inflation uplift produces additional capital expenditure for the same asset in subsequent periods. In our example these total 12,287 over the 30 years.

Initial and subsequent ‘capital expenditure for an inflation-linked lease
Initial capital expenditure and subsequent additions to the right of use asset for a 30-year lease, with initial lease payments of 1,000 that increase with inflation. The discount rate is 5.8% and the inflation assumption is 3% p.a.

The inflation uplift to the lease liability and right of use asset should be visible in the roll-forward disclosure for the lease liability (usually given as a component of the financing or net debt roll forward). In our view, if the impact is material for investors, then separate presentation is necessary, considering the disclosure objective of IFRS 16. However, in practice you may well find the impact is combined into an ‘other non-cash changes’ category.

US GAAP adopts a different approach. While there is a similar headwind, it manifests in a slightly different way. We explain the difference and implications below.

So how does this apply to Tesco?

The food retail company Tesco reported under IFRS 16 for the first time in their half-year results to August 2019. The lease obligation reported at that date is £10.3bn. Earlier this year the company provided investors with a detailed update on the effects of IFRS 16, which included a useful explanation of the accounting for inflation-linked leases. Click here to see this presentation.

Tesco disclosure of lease liabilities under IFRS 16
Source: Tesco half-year financial statements to August 2019

In their IFRS 16 transition presentation the company states that 77% of their leases have payments that are linked to the UK retail price index (RPI). Most of these leases originated several years ago when the company was restructuring its finances, including engaging in significant sale and leaseback activity.

Unfortunately, Tesco does not disclose the impact of the inflation uplift for its leases in its first reporting under IFRS 16. It is also not possible for us to accurately calculate the expected impact because it depends on the maturity and remaining term of the inflation-linked component of their lease portfolio and, of course, on what happens to RPI.

However, we can make an estimate. Based on a total lease liability of £10.3bn, the disclosed average remaining lease term of 12.9 years and the Bank of England market implied forward RPI spot rate for the next 3 years of 3.4%, we calculate the expected average depreciation uplift each year for the next 3 years to be £21m (£10.3bn x 77% x 3.4% / 12.9).

Operating profit and pre-tax profit headwind due to Tesco inflation-linked leases

This may not seem much considering that the last reported annual operating profit (restated for the effects of adopting IFRS 16) was £2,153m, but it does mean that operating profit growth will be roughly 1.0 percentage point lower that it would have been without the headwind effect. Of course, if the leases were not RPI-linked then, although the growth headwind would be avoided, the reported profit would itself have been lower. Non RPI-linked rental payments would have been higher for the same leased assets, resulting in a higher depreciation expense (at least until the lease portfolio matured).

The headwind applicable to pre-tax profit and net income is higher because the additional lease liability added each period also results in a higher interest expense. Based on the company’s disclosure that its average lease capitalisation discount rate is 5.8%, we estimate an annual interest expense increase of about £16m (£10.3bn x 77% x 3.4% x 5.8%). This produces an estimated total additional expense of £37m and a total headwind effect on pre-tax profit growth of 2.2 percentage points based on the last annual pre-tax profit. In other words, profit excluding the inflation effect would need to grow by 2.2% in order to offset the lease accounting headwind. The impact on earnings and earnings per share would be similar.

It’s not just the headwind you need to think about

It is unusual to exclude inflation from liability measurement in financial reporting. Other liabilities, such as pension obligations or environmental liabilities, must include the effects of inflation, either explicitly in the forecast cash flows, or by applying a real discount rate to the cashflows excluding inflation.

Inflation is included in the measurement of other liabilities

The liability most directly comparable to an inflation-linked lease is an inflation-linked bond. Like leases, inflation-linked bonds are measured at amortised cost; but unlike leases, there is an observable transaction price available. The issue price (the price investors are willing to pay) inevitably takes account of the inflation benefit. In effect, the inflation-linked bond liability is the present value of the maturity amount and coupon expressed in real terms (excluding inflation) discounted at the real interest rate implicit in that bond at the time of issue.

Inflation-linked leases, on the other hand, are measured at the real cash flows discounted at the same nominal interest rate that applies to leases without the inflation link. This understates the lease liability relative to other inflation-linked obligations and is the reason for the headwind catch-up adjustment.

We think that for the purpose of measuring indebtedness the effects of inflation should be included in lease liabilities. The best way to do this is to restate the liability using a real discount rate. If inflation-linked lease liabilities and right-of-use assets were stated at this higher amount, then this would also result in higher initial depreciation and interest expense, but it would avoid the subsequent headwind effect.

Adjusting the lease liability and right of use asset for inflation
This illustration is based on the assumption that the rate of inflation remains constant. Any fluctuation would introduce an element of volatility in the adjusted figures but not alter the general pattern presented.

Restating the Tesco lease liability

The discount rate Tesco applies to its portfolio of leases is an average 5.8%. If inflation were included in the measurement of the lease liability, the discount rate would have been lower – in effect reduced by the expected inflation at the time of issue.

It is not possible for us to accurately remeasure the lease liability to include inflation because we would need to know the real rate at the time each individual lease originated and more detail about the specific terms of the leases and their maturity. But we can do an approximate calculation.

Tesco has inflation linked bonds outstanding. One in particular gives us a clue as to its real cost of borrowing, the 1.982% RPI medium term note. This was issued at about the same time as when many of the RPI leases originated. The bonds were issued at par and hence the real yield was also 1.982%. In our view, using this rate would give a reasonable approximation of the lease liability adjusted to include inflation.  Using a real discount rate of 1.982% and an average lease term of 12.9 years, we estimate that the overall lease obligation would rise from £10.3bn to £15.2bn when adjusted to include inflation.

Be careful not to double count. If you allow for the profit growth headwind in your analysis of the performance of a company with inflation-linked leases, do not also reduce your valuation of the business by using a higher inflation adjusted liability. But, equally, do not ignore inflation entirely.

It is fair value that matters

In equity valuation it is not the book value of liabilities that counts, but rather the current fair value. In our article Enterprise value – calculation and mis-calculation we identify that not using fair value for debt obligations is one of the common mistakes in enterprise value based analysis.

Companies are required to disclose the fair value of financial instruments such as bonds. The Tesco disclosure below shows that the fair value of its long-term borrowings (which includes the RPI linked bonds) is significantly above the book value amortised cost.

Tesco fair value disclosure for financial instruments
Source: Tesco 2019 financial statements

However, IFRS disclosure requirements do not include the fair value of lease obligations and we doubt many companies will provide such a disclosure on a voluntary basis. To estimate the fair value, you need to identify a current real discount rate that would apply to the leases.

For Tesco, the current real yield on its RPI linked bonds is less than 1%. The fall in real yield and consequent rise in the fair value of these bonds reflects the recent general market change in real interest rates. If we apply this updated real yield to our estimate of the inflation-linked lease cash flows of Tesco, then the overall lease liability would be £16.9bn. You may notice that this is higher than the undiscounted lease payments disclosed by Tesco in the extract above. We believe this is because these undiscounted amounts are only the contractual minimum lease payments and do not include certain contingent rents or extension options that are reflected in the present value amount recognised in the balance sheet. But we cannot be sure.

Alternative measures of Tesco lease obligations
Source: Tesco half year report to August 2019 and IFRS 16 transition presentation, combined with our estimates.

Watch out for ‘leveraged’ inflation linkage

Inflation indexed lease payments may not necessarily reflect a simple 1 to 1 link. A lease could be structured where, for example, lease payments escalate each year at 1.5x inflation. This would result in a lower initial payment for the lessee, with near-term improvement to profit and cash flow and a lower initial lease liability. However, the consequence would be (1.5x) larger catch-up adjustments. For companies intent on managing the balance sheet presentation of lease liabilities, leveraged inflation linkage may be tempting.

Such an arrangement would be subject to the IFRS 9 embedded derivative provisions where, if the leverage effect does not meet the ‘closely related’ requirements, it would need to be separated as an embedded derivative and reported at fair value through profit and loss. In practice, it is generally assumed that up to 2x inflation leverage meets the requirement and would not be separated.

Although there is no specific disclosure requirement, the existence and impact of leveraged inflation-linked leases should be disclosed by companies, considering the disclosure principles in IFRS 16. However, you can always check by simply looking at the size of the inflation catch-up adjustment added to the lease liability. If this adjustment divided by the opening liability exceeds the inflation rate for the prior period, then you need to ask questions.

Tesco does not mention any leveraged inflation effect in their RPI-linked leases in either their IFRS 16 presentation to analysts or in their half-year report, so we assume there is none in their case.

US GAAP is different

In our article Operating leases: You may still need to adjust we highlight the difference between IFRS 16 and the equivalent US GAAP requirements in ASC 842. This primarily concerns the subsequent accounting for leases and the presentation of the lease-related expense in profit and loss. Remember that under US GAAP lease payments are reported as an operating expense in full rather than the IFRS 16 depreciation and interest expense.

US GAAP has a similar inflation-linked lease headwind but no update to the lease liability

A further difference relates to the subject of this article – inflation-linked leases. Under US GAAP, inflation-linked leases are measured at initial recognition in the same way as IFRS 16, i.e. not including the effects of anticipated inflation. However, the accounting differs in how the subsequent rise in lease payments due to inflation is dealt with. For US GAAP the liability and right of use asset are not updated by the change in prices. Instead the extra amount of lease payments due to the inflationary increase is simply charged to profit and loss as it is paid.

The lack of updating for inflation means that US GAAP liabilities for inflation-linked leases will be lower than under IFRS 16 at all times after initial recognition. The same profit headwind effect is present in US GAAP, but this is fully in operating profit. Adjusting for this difference will not be easy.

Implications for equity valuation

The accounting for inflation-linked leases impacts both DCF and valuation multiple approaches to equity valuation.

Discounted enterprise cash flow

We recommend that lease liabilities are included in enterprise value and that free cash flow should not include any deduction for lease payments, but should be stated after deducting the ‘effective capital expenditure’ related to leases. For more about effective capital expenditure due to leasing see our article When cash flows should include non-cash flows.

If the reported lease liability (i.e. excluding inflation) is included in EV then you should make sure that forecast capital expenditure includes not just the effective capital expenditure from new leases, but also the effective capital expenditure arising from the inflation uplift for existing leases. Alternatively, you could restate the lease obligation to include the inflation effects. In that case, only the capital expenditure arising from new leases should be included in free cash flow.

Valuation multiples

Valuation multiples are affected by forecast growth. Therefore, if the profit metric used in valuation multiples is affected by the lease inflation headwind, then the deserved multiple that should apply would be lower than it otherwise would have been. This would apply to price earnings ratios and EV multiples based on reported results. If the lease liability were to be restated to include the effects of inflation, and performance metrics adjusted accordingly, then no valuation multiple discount would be warranted.

Insights for investors

  • Remember that reported liabilities for inflation-linked leases do not include the inflation effect.
  • Inflation-linked leases could have a material impact on future profit growth due to the headwind effect.
  • The lease catchup adjustment for inflation, in effect, represents additional capital expenditure, but with no increase in productive capacity.
  • Allow for the leasing inflation headwind but don’t double count by also restating the lease liability.
  • For comparable leverage information, adjust lease liabilities linked to inflation to reflect a real discount rate.
  • Your calculation of enterprise value should include the fair value of debt, including lease obligations.
  • Watch out for leases where the link to inflation is leveraged. This will understate the liability even more, further overstate profit in the early years of a lease and produce a higher headwind effect.

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