The biggest upheaval since International Financial Reporting Standards (IFRS) were introduced to Canada in 2011 is the new requirement to put almost all leases on company balance sheets.

This requirement doesn’t come into effect until January 1, 2019, but the impact is so large that the OSC has already taken an interest in how companies are handling the transition in financial reporting.

By some estimates, the new standard will add US$3 trillion in assets and liabilities globally to corporate balance sheets, significantly altering perceived leverage, profitability and other key financial metrics, including cash flows.

The current method: two kinds of leases

Under current accounting rules, operating leases and capital leases differ. A capital lease (also called a finance lease) records both an asset and liability on a company’s balance sheet, with the associated lease expense recorded on the income statement as interest and depreciation.

Under IFRS, a company (as the lessee) is supposed to use a capital lease treatment under various conditions including, but not limited to:

  1. when substantially all of the risks and rewards are transferred to the company; or
  2. if the term of the lease covers most of the economic life of the asset; or
  3. if there is a bargain purchase option at the end of the term.

Any lease that isn’t a finance lease is considered an operating lease. The lessee, in these situations, doesn’t record any asset or liability on the balance sheet, and the lease payments appear as operating expenses on the income statement.

Operating leases have always provided an easy source of off-balance-sheet financing, and many leases are deliberately structured to create that advantage for companies.

The new method: one kind of lease

Under IFRS 16, there will be only one kind of lease: the finance lease. Aside from certain exceptions, such as leases less than a year in duration, the vast majority of leases that are currently recorded as operating leases will need to be reclassified.

This will be a monumental amount of work, but, once done, the burden shifts to investors to navigate the impacts on financial statements and to avoid serious valuation mistakes.

Changing financial ratios and metrics

The list of ratios and financial line items impacted by the new rules is long and significant. Investors will have to reset their expectations when it comes to several financial metrics.

For example, many companies will report substantially higher EBITDA, since operating lease payments will no longer be subtracted from above the EBITDA line. Some studies put this increase in the range of 10% to 15%. Instead, these charges will appear as depreciation and imputed interest, and go below the EBITDA line.

Likewise, the return on assets will decrease as a result of companies reporting similar income on a much higher asset amount. Leverage ratios, such as debt to equity, and interest coverage will be affected. Net income could be lower because of accelerated expense recognition.

Cash flows

Some analysts try to slough off the impact of new accounting rules on valuation with the argument that underlying cash flows aren’t affected. As usual, this argument holds no water. Financial statements always deal with reported cash flows, not actual cash flows—a fact most investors ignore at their peril.

Investors should always keep in mind that valuation based on cash flows comes from the cash flow statement. Yet the cash flow statement’s starting point is accrual income, which is heavily influenced by accounting rules.

Currently, cash flows related to existing operating leases are subtracted from the operating cash flow section of the cash flow statement. Under the new rules, those same cash flows will be deducted from a mix of financing, investing and operating cash flows.

The depreciation portion of the cash flows should be reported under financing activities on the cash flow statement. However, the interest portion is a different story. While it would be best for investors to see the interest expense subtracted from cash from operating activities, as we’ve explained in a previous article (see AER, February 2014), interest expense can appear anywhere on the cash flow statement under IFRS.

In almost all situations, cash flow from operations will be higher than under the old rules, and investors have to seriously question free cash flow figures as well.

Another ongoing problem is the split between interest and depreciation, since those depend significantly on management assumptions.

A final major area of concern is whether the accrual figures (including cash flow statement amounts) could differ significantly from actual cash flows. This possibility can’t be ignored at this stage, since companies are only starting to explore the leeway under the new rules, especially in terms of valuing the liability on the balance sheet.

Major valuation impact

The new accounting treatment will be a hard transition for investors and advisors. It will transform company valuations on a relative basis, and will permanently skew widely used metrics like EBITDA, EBIT, valuation multiples, leverage and coverage ratios, and cash flows.

Advisors will need to start monitoring companies as they report the impact of the new rules on their financial statements. This will help advisors identify the companies and industries most affected, which is the first step in dealing with this monumental reset of corporate financial statements.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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