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IFRS 16: How this new accounting standard will affect companies and your stock investments

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In the April 2008 edition of the Empire Club of Canada forum, former chairman of the International Accounting Standards Board (IASB) Sir David Tweedie famously said: ‘One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.’

This quote,
likely said in a jocular manner, is frequently mentioned in any conversation
about IFRS 16 – a new amendment to the International Financial Reporting
Standards that radically changes the method in which operating leases are dealt
with.

Making this
point using the airline industry is understandable, given that it is common
practice for airlines to operate aircraft under short-term leases that are not
reflected on their balance sheets. As IFRS 16 took effect on 1 January 2019,
Sir Tweedie has finally realised his lifelong desire. Companies will now have
to recognise the financial commitment that accompanies lease agreements on
their balance sheets.

Undoubtedly,
this complicates matters for investors, causing otherwise unexplainable changes
in popular metrics like the debt-to-equity ratio and operating profit. However,
this technique of dealing with operating leases serves to increase transparency
on the financial statements, revealing the full extent of a firm’s financial
commitments. In this article, I will walk you through exactly what has changed,
and how this will impact the companies’ financials.

IAS 17: The former standard

Under the
former standard, IAS 17, the expenses associated with operating leases were
simply recorded in the income statement as an operating expense. That was it. There would be no signs of the
lease in the other financial statements, even though the company may have
committed to a multi-year lease.

This
presented a large problem for investors analysing companies with a large
portfolio of leases. Take Chico’s FAS, a U.S.-based apparel retailer. At the
end of fiscal year 2017, the company had shareholder’s equity of US$656 million
and had US$247 million more in current assets than current liabilities. Coupled
with the US$101 million the company generated in 2017, it seems like the
company has a rock-solid financial position.

However,
deeper research reveals company had committed to a total of US$931 million of retail
leases over the next five years, with US$191 million due in one year or less.

Source: Chico’s FAS 2017 annual report

To be
clear, I did not cite this example to criticise Chico’s current financial
position. Rather, it serves to emphasise that under former accounting
standards, Chico’s balance sheet did not portray the full extent of its short
and medium-term liabilities.

IFRS 16: Operating leases
as debt

IFRS 16
changes a lot of that. Under the revamped accounting standard, a firm’s
operating lease commitments will be expressed in the balance sheet as either short-term or long-term debt, depending
on when payment is due. At the same time, a corresponding right-of-use lease
asset will be recorded on the asset side of the balance sheet.

As a result, lease payments are amortised based on the value of the asset, and reclassified as depreciation expenses and interest payments. I will not go into the details of how amortization figures are calculated, but it is similar to the way auto loan or mortgage loan payments are computed. In the following sections, I’ll go through the changes that will take place on the companies’ financial statements.

The income statement

After IFRS 16 takes effect, operating lease payments will be reclassified
and recorded under the ‘Depreciation & Amortization’ and ‘Interest Payments’
line items. 

As a result, metrics that back out interest and depreciation, such as EBIT
and EBITDA, will experience a significant boost as a result of this new
accounting standard, reducing the value of popular ratios like EV/EBIT and EV/EBITDA, which can make the company at hand seem undervalued.

Luckily, the net income figure will not change significantly as most costs
are simply shifted down the income statement. This means that net profit-based
ratios such as the price-to-earnings ratio
will not be affected too significantly.  

The balance sheet

On the liabilities side of the balance sheet, an ‘operating lease liabilities’ line item will be added to represent the total amount of operating leases a company has committed to paying, discounted to its present value. At the same time, a corresponding asset, commonly named ‘operating lease right-of use asset’ will be recorded on the asset side of the balance sheet. The value of the asset and the liability should be equal at the onset, but the two values can diverge over time due to the concept of straight-line depreciation.

The image below shows the balance sheet of Microsoft which chose to
adopt IFRS 16 in 2017, two years ahead of time:

Given that operating lease liabilities are now classified as a type of long-term
debt, metrics such as the debt/equity ratio,
debt/capital ratio, and the interest coverage ratio will be
affected heavily. Companies with a large portfolio of leases will see these
ratios increase heavily.

At the same time, it is noteworthy that this change will also increase
the level of invested capital in a company, given the increase in total assets.
This means that measures of profitability such as return on invested capital (ROIC) may take a hit if the increase in
operating capital outweighs the increase in EBIT.

The cash flow statement

In the cash flow statement, operating lease payments — which used to be
classified as an operating expense — will now be recorded as a financing expense. This means that net
cash flows will not change, but metrics like operating cash flow and free
cash flow
will increase for a company with a large portfolio of leases.

IFRS 16’s impact on companies
you own

The impact of this new accounting standard varies for different
industries, and as one might expect, companies that need to maintain a
significant portfolio of leases will feel the greatest impact.

As seen below in a table extracted from a PwC report, the median
increase of debt and EBITDA for a U.S. company is 22% and 13% respectively. For
retailers that need to rent brick-and-mortar stores to reach customers, the
median increase in debt and EBITDA is substantially higher, at 98% and 41%
respectively.

Source: PwC

The fifth perspective

The IFRS 16
change is one of the most significant accounting standard changes in years.
While some may feel that this makes it difficult for investors to compare some widely-used
financial metrics across time periods, the benefits that accompany this method
are manifold and should be embraced.

After all,
most of the dirty work — such as restating of financials — will be done by the
companies’ accounting departments, with investors simply on the receiving end
of that data.

In summary, you can refer to the table how IFRS 16 will affect a financial metric or ratio:

Financial Metric/Ratio Impact of IFRS 16
EBIT, EBITDA Higher
Earnings No change
Total Assets Higher
Total Liabilities Higher
Total Debt Higher
Operating Cash Flow Higher
Free Cash Flow Higher
EV/EBIT, EV/EBITDA Lower
Price/Earnings No change
Debt/Equity, Debt/Capital Higher
Interest Coverage Ratio Lower
Return on Invested Capital Higher
Price/Operating Cash Flow Lower
Price/Free Cash Flow Lower

Happy investing!

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