Takeaways From Last Week’s Digest: IFRS 16

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We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback! Click here to receive both posts weekly via email.

 

Our weekly readers know that we have a few contributors who share notes with us on conference calls that they read.  One of those contributors is Erick Mokaya, a talented young analyst based in Europe.  Last week Erick shared a quote that he picked up in a Tesco earnings call about IFRS 16.  Here was the quote:

“IFRS 16 has got a lot of complexity, not only in terms of the going forward implication but the actual point of implication. And it will change very significantly the way that all of us look at the balance sheet and the P&L, as a result, no change to cash clearly, because it’s a no economic change…We’re spending a lot of time thinking through it.” —Tesco CEO Dave Lewis (Retail)

This week I asked Erick to write a brief explanation of IFRS 16 for our readers.  The new accounting standard affects lease treatments and is likely to have a significant effect on financial statements in a variety of industries.  Below is Erick’s work.

I would also like to mention that Erick is currently looking for an entry level role at a buyside investment firm (likely in Europe but he is flexible on location).  I have been extremely impressed with Erick’s work and give him a whole-hearted recommendation.  If you are looking for a bright, dedicated, diligent young analyst please respond to this email and we will connect you with Erick.

 

IFRS 16: A New Life for Leases

Off-to-on Balance Sheet

Deep in the throes of the Great Recession, former International Accounting Standards Board (IASB) Chairman Sir David Philip Tweedie, in an oft-cited quote from a speech at The Empire Club of Canada, remarked that: “one of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.” His remark was motivated by the fact that most airline companies use operating leases that appear as off-balance sheet items. Notably, the IASB estimated that although 2014 total leases around the world were worth around US$3.3 trillion, only less than 15% of these appeared on balance sheets as they were classified as finance leases. The rest, classified as operating, only appeared in the notes and were considered off-balance sheet.

Earlier this year, Tweedie´s wish came true as the IASB issued IFRS 16 on leases that is meant to blur the lines between finance and operating leases bringing more of the latter onto the balance sheet. A month later, the US Financial Accounting Standards Board (FASB) issued an Accounting Standards Update(AUS) meant to deal with the same. It has been a long and tedious road to changing the accounting for leases. As regards convergence, the new approaches by the IASB and FASB changes are similar in most respects except that the FASB allows the distinct treatment of former off-balance sheet items by the lessee. The IASB does not expect this to result in significant material differences in the resulting financial statements.

Key Implications

IFRS 16 will replace the current IAS 17 on leases. The main change is that classification of leases as finance or operating lease will be eliminated for lessees. All leases are to be treated similar to finance leases in IAS 17. The new standard becomes effective from 1 January 2019. (Earlier implementation is allowed as long as IFRS 15 Revenue from Contracts with Customers is also implemented). Companies can choose between a full retrospective approach or a modified retrospective approach in implementing the standard. Lessors will remain generally unaffected and will continue to classify leases as finance or operating. Leases for a short period of time (12 months or less) and those of assets of low-value are exempt. The key implications on the 3 key financial statements are below:

  • Expanding Balance Sheets: Companies will recognize the present value of lease payments as lease assets or PPE. Lease payments when made over time are recognized as financial liabilities. The result is an increase in assets and liabilities with companies with significant off-balance sheet assets to be affected. Further, there may be a slight, mostly insignificant, decline in equity.
  • Realigned Income statements: Lease expenses relating to operating leases in IAS 17 which have treated an operating expense will now be charged as depreciation on leased assets and interest expense on lease liabilities (finance cost). As a result, EBITDA and EBIT will increase but with little to no effect on profit before tax. While depreciation can be stable, interest expenses tend to be front-loaded and taper off as the lease period nears the end. Total expenses will therefore decrease over the period of the lease.
  • Unchanged CashFlow Totals: Cash outflows from operating leases that were previously taken to be operating expenses will be treated as financing activities. The new IFRS is expected to have an increase in cash from operating activities with an offsetting decrease in cash from financing activities leaving total Cashflows will not change.

As a result, financial ratios will be affected especially the leverage ratio and, asset turnover. Companies may incur additional costs in implementing the new standard also but the IASB expects the new standard to require no more data as is needed for IAS 17 although the data collection may need to be more frequent. Businesses will also have to reconsider leases as a financing option also. Debt covenants may need to be adjusted while costs of borrowing may be affected. Notably, there are some disclosures that need to be made even before IFRS 16 becomes effective.

Changes ahead

What are the benefits of the new lease standard? The key benefits lie in financial statements that faithfully represent the underlying economic transactions more faithfully with an additional advantage to improved comparability across companies. IASB Chairman Hans Hoogervorst puts it well in the press release[i] for IFRS 16 that it is meant to help end “the guesswork involved when calculating a company’s often-substantial lease obligations.” This guesswork is where analysts themselves rather than the companies try to estimate the amount of operating leases and liabilities to add to the balance sheet to make the financial statements give a better picture of the health of the company. Further, it will “provide much-needed transparency on companies’ lease assets and liabilities” and “improve comparability between companies that lease and those that borrow to buy.”

Companies that would be most affected are those in industries prone to off-balance sheet financing in industries like airlines, Travel, Transport and leisure, and retailers with the IASB estimating that half of all listed companies will be affected. Some of the companies that may be affected like Tesco are beginning to assess the impact. In the last financial year, Tesco had £17.3 billion worth of non-current liabilities on the balance sheet with an additional £13 billion of non-cancellable operating lease commitments disclosed in the notes.

Conclusion

In sum, IFRS 16 presents a significant shift in accounting for leases and investors and analysts alike would do well to pay attention to its effects on financial statements and business practices. Further, we would tend to agree with the closing comment from the panel at the joint ICAEW & IFRS Foundation Conference discussing the new standard that “IFRS 16 is a force for good.”
[i] Press release at http://www.ifrs.org/alerts/pressrelease/pages/iasb-shines-light-on-leases-by-bringing-them-onto-the-balance-sheet.aspx