With all the other excitement going on in the world at the moment, it is possible you missed out on the introduction of the latest International Financial Reporting Standard (IFRS) at the beginning of January.
Should we spot sufficient demand from our readers, here on The Value Perspective, we will gladly run a series profiling the full set but, today, our focus is on the shiny new IFRS 16.
This sets out “to report information that (a) faithfully represents lease transactions and (b) provides a basis for users of financial statements to assess the amount, timing and uncertainty of cashflows arising from leases”.
That aim is certainly to be commended but, as we shall see, it also has the potential to cause investors a fair amount of confusion – at least in the short term.
Not all investors choose to scrutinise company accounts, of course, but it is an integral part of our investment process, here on The Value Perspective – and the curious way businesses have hitherto been able to treat leases on their balance sheets is something we have discussed before, particularly in the context of the retail sector, in pieces such as Early warning sign and Carpetright’s big flaw.
What IFRS 16 is trying to do is end the distinction companies have been able to make between financial commitments known as ‘operating leases’ (where a company has the right to use an asset, but doesn't own in), which could sit ‘off-balance sheet’, and other types of lease, which needed to be included.
The obvious advantage of having financial commitments 'off-balance sheet' is that they don't affect the company's perceived liquidity (paying its debts using its own assets). A company with higher liquidity could be seen by some investors as less of a risk to invest.
We would not dream of suggesting every business would set out to game this particular system by obscuring the extent of their debts but, when the temptation exists, some will yield to it.
So IFRS 16 sets out to establish a framework wherein businesses provide a clearer picture of their finances in their accounts.
A very laudable aim then, as we say, but one that remains – to use a fine accounting term – a work in progress and, while it is still very early days, it is clear a couple of serious issues risk preventing the rule’s objectives from being fully achieved.
Snag #1 with IFRS 16 - Interpretation
The first issue is perhaps a question of interpretation, with the way companies now appear to be choosing to represent these ‘new’ debts on their balance sheets being quite some way removed from what you might expect; from the kind of adjustments people used to make to bring such things onto their balance sheets; and certainly from the kind of adjustments we ourselves would make, here on The Value Perspective.
Let’s take the real-life illustration of Company X - a Danish shipping business (not its real name obviously).
Sometimes shipping companies own the ships they use and sometimes they lease them so this is classic IFRS 16 territory.
In the past, while a business did not have to offer much in the way of detail about its operating leases, it would at least have to indicate its total future commitments in that regard which, for Company X, was $1.3bn (£1bn).
And while that is almost certainly far less than the number we would have calculated ourselves as the real liability on the company due to the leases, as a result of IFRS 16, the total liability Company X is now putting on its balance sheet is around 75% lower – $350m.
The danger here, we would suggest, is that investors may assume the introduction of IFRS 16 has solved the problem of how operating leases are flagged up on company balance sheets.
The reality, however, is the real economic liabilities are still the same but, as a result of how the new standard is worded, the new liabilities going into company balance sheets are tending to be much smaller than one would expect.
To what extent this represents flaws in the wording of the new rules or, say, companies tweaking their arrangements to minimise their effects is, at this point, difficult to judge.
A possible workaround to mislead
One way a shipping business could do this, for example, would be to sign very short-term leases when it charters its ships – a few days short of a year, say – so it does not have to include them in its accounts.
That is because IFRS 16 does not require ‘short-term’ leases to be considered – even where it is highly likely the company will keep renewing those leases.
That said, a shipping company might have some genuinely good reasons for organising things this way – for example, to enable it to vary the size of its fleet in response to any demands made at short notice.
Even so, the first issue IFRS 16 faces is the age-old one that, if you come up with a new rule, some people are always going to try to find ways round it.
We shall consider the second issue in Snags with new accounting rules #2.