In Snags with new accounting rules #1, we highlighted the latest International Financial Reporting Standard (IFRS) – number 16 – which was introduced at the beginning of January and 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”.
While undeniably a most laudable aim, we suggested there is now the potential for a fair amount of confusion among those investors who choose to scrutinise company accounts – first, as we saw, in relation to how businesses are choosing to interpret IFRS 16; and second, as we will now cover, with regard to making proper comparisons between the accounting environments before and after the rule’s introduction.
Snag #2 - comparing businesses is trickier
Obviously this should prove a more short-term issue but IFRS 16 does have the effect of shifting where certain costs sit in different lines of a business’s accounts – for example, the cost of a lease is now split between a company’s operating costs and its interest payments.
This is particularly important to understand if you are looking at businesses on the basis of their free cashflow.
For example, you might see a boost in the business’s free cashflow and, if so, you should understand this may have nothing to do with the company performing better.
Rather, it has everything to do with a rule change that has removed 'lease costs' from the 'operating' section of the cashflow statement (which is part of free cashflow) and moved them to the 'financing' section. The financing section is not part of the free cashflow, given it handles movements in debts.
Before or after the rule changes?
Also, at present, when companies are giving guidance about their expected financial performance, it is often not clear whether they relate to before or after the rule changes.
Human and corporate nature being what it is, though, if it is after the rule changes, businesses tend to draw a lot more attention to any extra ‘debt’ going onto their balance sheets than to how any profit or cashflow guidance may be enjoying an artificial boost from the changes in the numbers.
Operating profits may also be boosted because a portion of the old operating lease charge is now allocated to interest instead.
The US is changing methods too - just differently
Just to introduce one more wrinkle to an area that is hardly short of complexity, the powers that be in the US are pursuing a similar aim of better reflecting operating leases in company balance sheets – just slightly differently.
That is because they have decided to leave unchanged how this is reflected in a business’s cashflow and profit & loss numbers.
Reasons for the US approach include avoiding the artificial precision of IFRS 16, whereby the lease charge is allocated between depreciation and interest – not to mention the potential for companies to game that aspect – and to retain a historic link with previous sets of accounts.
Arguably this makes for a better outcome but it does mean IFRS accounts are now difficult to compare not only with the past but also across geographies.
As such, investors do need to be aware of the potential for confusion in the short term and indeed the potential for misunderstanding over the longer term.