New accounting rule could have a big impact on corporate net debt levels
There hasn’t been any fanfare or special announcement, but 1 January saw the introduction of one of the biggest changes in corporate accounting for decades.
While analysts and investors will be busy poring over 2018’s results for many weeks to come, for most firms the impact of the new regulations won’t become clear until they start reporting interim 2019 numbers much later this year.
WHY DOES THE NEW RULE MATTER?
The new rule is International Financial Reporting Standard (IFRS) 16 and it brings radical changes to the way corporate results account for operating leases.
Under the old International Accounting Standard (IAS) 17 which dates back 30 years, operating and finance leases were treated differently with operating leases allowed to be kept ‘off the books’.
This wrinkle allowed many companies to hide the extent of their lease obligations and flatter their results, while other companies which paid for assets through debt rather than leasing them saw their earnings depressed.
From 1 January operating and finance leases will be treated as one and the same thing and will be accounted for on-balance-sheet, with companies recognising an asset and a liability together with a finance charge and a depreciation charge.
WHAT IT MEANS FOR YOUR INVESTMENTS
The sectors which make the most use of operating leases and therefore are going to have to make the biggest changes to their reports and accounts are retail, travel and leisure, transportation, distribution and healthcare.
The effect on their profit and loss accounts will be to increase earnings before interest, tax, depreciation and amortisation (EBITDA) but also to increase finance costs, while on the balance sheet financial liabilities will rise as will net debt.
For some companies the increase in EBITDA will make them look cheaper or more profitable than they actually are, but the resulting increase in net debt could be an issue if they are already operating close to their target level of net debt-to-EBITDA.
Also a company may turn out to have much greater financial liabilities than previously estimated, which could affect the way investors and business counterparties view it in future.
WHERE THE RULES MIGHT THROW UP BIG SURPRISES
Airlines are big users of lease finance but the extent of their off-balance sheet exposure has been reasonably well understood for many years so there are unlikely to be too many surprises when they report.
However retailers such as Tesco (TSCO) and Sainsbury (SBRY) which lease some stores instead of owning them directly will see a big change in the accounting treatment of their leases, leading to an increase in their liabilities and their net debt positions.
‘We predict the newly recognised lease liabilities will often be large,’ says Dylan Whitfield, head of forensic accounting at HSBC. ‘For example, we estimate that net debt will quadruple for Tesco and double for Morrison (MRW), and calculated earnings per share will decrease. Their operating lease commitments may also be bigger than previously disclosed. Income statements could also become more volatile.’
Tesco took the initiative by briefing analysts earlier this month on the introduction of IFRS 16 and the differences it would make to the firm’s financial statements and performance measures.
As the company rightly says, the new accounting rule has no economic impact on its business nor does it change the way the business is run, but it has a significant impact on the way assets and liabilities are classified and the classification of cash flows.
Using its first half 2018-19 financial statements, under IFRS 16 Tesco showed a 20% increase in operating profit as rent was removed from its costs, but a 14% decrease in pre-tax profit due to higher interest costs and depreciation.
The swings were almost as big on the balance sheet with a 10% reduction in net assets and a 25% increase in total debt due to the reclassification of lease liabilities.
EXPECT THE FOLLOWING TO HAPPEN:
– Companies with a December year end will likely restate their 2018 earnings on an IFRS 16 basis as well as their 2019 earnings to compare apples
– Some companies with different financial year ends have already restated their 2017 earnings so that 2018 earnings are comparable.
– The biggest change to the profit and loss account is a reduction in operating costs and an increase in earnings before interest, tax, depreciation and amortisation (EBITDA). However under IFRS 16 firms will have to increase their interest and depreciation charges so for many of them pre-tax earnings may be negatively affected by the changes.
– Valuation models which use EBITDA as a measure of profitability (EV/EBITDA for example) or financial health (net debt-to-EBITDA) will need to be rethought. Even models using earnings per share will need to be rethought including the most basic measure of valuation, the PE (price-to-earnings) ratio.
– The inclusion of operating leases in a company’s total debt affects the net debt-to-EBITDA ratio which in many cases forms part of the banking covenants. Lenders are unlikely to insist on redrafting their agreements purely on a change in the accounting rules.
– As always, some companies may be more ‘creative’ with their accounting so it will pay to be vigilant.