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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.
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.
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 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.
After IFRS 16 takes effect, operating lease payments will be reclassified and recorded under the ‘Depreciation & Amortization’ and ‘Interest Payments’ line items.
While popular metrics like EBIT and EBITDA will experience a significant boost as a result of this new accounting standard, the increase in debt for most companies outweighs the impact of this boost. This ultimately increases the value of popular ratios like EV/EBIT and EV/EBITDA, making the company look more overvalued than before.
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.
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.
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.
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.
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|
|Operating Cash Flow||Higher|
|Free Cash Flow||Higher|
|Interest Coverage Ratio||Lower|
|Return on Invested Capital||Higher|
|Price/Operating Cash Flow||Lower|
|Price/Free Cash Flow||Lower|