A ten-year lease that escalates at 7% per year – vs the average rental price a company must report in its books.
  • Accounting rules require motor company CMH to report average rental payments over the period of a lease – instead of what it actually pays, says its CEO.
  • In the countries where the rules are written, and inflation is low, that may not be a big deal.
  • But in South Africa it distorts financial results badly, and may actually encourage companies to not invest in new lines of business. 

Rules around how companies must report on their rental payments distort financial results – and actually discourage companies form investing in new lines of business "with a high property component," Jebb McIntosh, the CEO of Combined Motor Holdings (CMH), said on Tuesday.

And he believes South Africa is suffering the consequences of rules written for Western countries, with a financial reality very different from that in other countries.

Highly unusually, McIntosh - a chartered accountant - included something of a rant about the accounting principles for property rental in his company's annual results published on Tuesday.

"Of concern to me is the disturbing impact which some accounting principles can have on the economic realities of business," McIntosh wrote to investors.

His problem is with the way payments for property leases must be account for company's books.

Under current rules rental payments must be averaged over the term of a lease; for a ten year lease that totals R100 million over that decade, a company must report R10 million in expenses every year.

But that's not how rentals actually work in the real world.

"In respect of a 10-year lease with 7% annual escalations, the charge to the income McIntosh statement in year one will be 138% of the cash rental paid," McIntosh wrote.

Put differently, a building with a R10 million a year rental cost and a 7% annual escalation will cost R10 million in year one – and R18.4 million by year ten. But the renting company must report that it pays R13.8 million, the average annual rental over the ten year period.

Jebb McIntosh

In this first five years of the deal the rental on the company books is overstated, in year six it is close to accurate – and for years seven to ten the company is reporting a rental much lower than what it is actually paying.

In countries like the US and the UK the rate of inflation is roughly half that of South Africa – which makes the distortion in results far smaller.

"It would seem South Africa and emerging markets are completely disregarded by these guys who live in a low-inflation environement," McIntosh told Business Insider South Africa about the drafters of accounting rules.

He believes the distortion "absolutely" holds back investment in South Africa.

"You can't do one-year leases in a lot of cases, you need continuity," he says. 

But a CEO on a five-year contract who signs a 10-year lease could report notably worse results than one who does not start a new line of business that requires property.

In its last financial year to the end of February CMH reported headline earnings nearly 3% lower than they would have been without the rental-rules distortion, McIntosh says.

And under new rules it must implement in March 2019, the distortion will be even worse.

Receive a single WhatsApp message every morning with all our latest news: Sign up here.

See also: