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One-Off Items Field Guide: Onerous Leases

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One-Off Items Field Guide: Onerous Leases

Something that has caught our eye recently is a prevalence of companies taking onerous lease provisions as part of their financial reporting.

In simple terms, an onerous lease provision arises where a company assesses that its obligations under a lease agreement exceed the benefits likely to be received.  Rather than expense the lease payments as they are incurred, the company raises a provision at the time it makes the assessment, and in this way a chunk of what had been regular operating expenses get allocated to a “below the line” item, excluded from so-called underlying earnings.

There can be a good rationale for this sort of treatment. For example, if a company shuts down its operations at a particular leased location and is unable to re-let the space for the remainder of the lease, it is probably helpful to recognise the relevant lease costs as something that will at some point disappear; not needed to operate the continuing business.

In some cases, however, a company will continue to operate at a site as normal but, having determined that the operation cannot make sufficient profit to justify the relevant lease costs, it will “correct” that by taking a one-off provision and then reporting a lower lease cost going forward as the provision is released through the P&L.

There are a couple of points to keep in mind here.

Firstly, the cash will continue to flow. The reported earnings may be higher in future periods as a result of the onerous lease provision being gradually released, but that doesn’t mean the landlord is getting paid any less.

Secondly, unlike some other one-off items which can be positive or negative, this kind of provision tends to be a one-way street.  You won’t see many companies raising a negative provision and then reporting increased future lease costs if they find themselves with unduly favourable lease arrangements.

Thirdly, an onerous lease provision can look similar to a write down of goodwill, in that it provides one-off recognition of unsatisfactory financial performance of an operating asset, but with one important difference. In the case of a write down of goodwill there is no change to future reported earnings, just a one-off hit to reported earnings at the time of the charge.  In the case of an onerous lease provision, recurring lease costs can be taken out of future periods and put into a one-off charge today, to the benefit of future reported earnings.

This may all be in accordance with reporting standards, but investors need to be on their toes.  When a company removes large one-off charges of any kind in calculating “underlying” earnings, it can be tempting to take the underlying number at face value. However, is wise to focus a bit of time on those one-off charges and understand where they come from, whether they are truly one-off, and how they might impact future earnings.

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Tim joined Montgomery as Head of Research and Portfolio Manager of The Montgomery Fund in July 2012. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Before joining Gresham Partners, Tim worked for McKinsey & Company for four years, where he was involved in strategic consulting in both Australia and Denmark.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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Comments

  1. Hi Tim

    I’m always wary at looking at the P & L in isolation as it can easily be manipulated and mislead , whereas the Statement of Cash Flow is a more foolproof way of assessing Business performance.

    Comparing Operating Cash Flow to underlying earnings over a period of years is a more sound method to identify negative or positive trends – It’s not impossible to falsify the SOCF but much harder than with the P & L – the money is either in the Bank or it isn’t – the underlying profit can be whatever number some creative Accountant wants it to be.

    What is interesting to note is that many analysts focus on underlying earnings per share growth as the main driver of share prices. So, If the underlying EPS number can be easily manipulated why so much emphasis on that number?

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