How an Accounting Rule Significantly Affects Your Fundamental Analysis
In today’s post…
This post was originally posted here. The writer, Vincent Wong is a veteran community member and blogger on InvestingNote, with a username known as @vincentwong and has close to 805 followers.
“IFRS 16, or International Financial Reporting Standard 16, is an accounting standard that took effect on January 1, 2019. It primarily addresses the accounting treatment for leases, significantly impacting companies that are lessees (tenants) and how they report their lease arrangements on financial statements. The most affected industries include retail, food and beverage, and airlines that don’t own their airplanes, among others.
In this article, you’ll gain a basic understanding of the accounting standard using Kimly as an example and learn how to adjust your fundamental analysis.”
Before and After
Before IFRS 16, operating leases generally weren’t recognized on a company’s balance sheet. Instead, they were treated as off-balance-sheet items, with lease payments recognized as an expense in the income statement. This approach often resulted in a lack of transparency in financial reporting since the company’s lease obligations weren’t clearly visible on the balance sheet.
Under IFRS 16, lessees must recognize a right-of-use (ROU) asset and a lease liability on their balance sheet for all leases, with limited exceptions. This new approach affects companies that lease in the following ways:
- Balance Sheet: The right-of-use assets and lease liability are recognized on the balance sheet. The right-of-use asset represents the lessee’s right to use the leased property (e.g., restaurant premises) during the lease term, while the lease liability reflects the present value of future lease payments. This recognition increases both the assets and liabilities on the balance sheet.
- Income Statement: Rather than recognizing the entire lease payment as an expense, the income statement now reflects the depreciation of the right-of-use asset and the interest expense on the lease liability. Depreciation is typically recognized on a straight-line basis over the lease term, and the interest expense decreases over time as the lease liability is reduced. This change can lead to a lower total expense in the early years of a lease, potentially increasing the company’s reported operating profit.
- Cash Flow Statement: Lease payments are now divided into two components: the principal portion, which reduces the lease liability and is presented as a financing cash outflow, and the interest portion, which is classified as an operating cash outflow. This reclassification may improve operating cash flow, as the principal portion of lease payments is now presented within financing activities.
The accounting standard affects industries where leases comprise a significant part of their capital structure, such as restaurant groups that rely on renting commercial space to operate their business or shipping companies that charter ships from vessel owners to conduct their operations.
Do take note that although IFRS 16 affects the lessee, it doesn’t affect the financial structure of lessors(asset owners) like REITs to the same degree.
Example: Kimly (1D0)
Using a restaurant group listed on SGX, Kimly, as an example, these changes can have several implications:
Kimly had virtually no long-term liability (Black Bar) in 2019, but its long-term liabilities and long-term assets increased significantly in FY2020. This is due to the inclusion of lease contracts as liabilities in the balance sheet. To balance the account, a right-of-use asset is added to the long-term asset (Dark Green Bar).
The Net Cash Flow from Operating Expense has increased significantly due to the adjustment of “Depreciation of ROU asset” in the cash adjustment (which adds back the rental accounted in P/L) in a way that is similar to cash add-back adjustment for ordinary depreciation.
The Net Cash Flow from Financial Activities has a significantly higher outflow due to the inclusion of lease liability payment (which is paying the rental).
The traditional FCF calculation is typically Cash Flow from Operations minus Capital Expenditures. However, as aforementioned with the changes in cash flow statements, this method does not reflect the underlying cash that companies can use freely. So, a more appropriate approach should be minus the repayment of lease liabilities (Rental made to fulfill lease obligations) :
(Net Cash From Operations + Interest/Dividends Received – Net Interest Paid – Capital Expenditure – Repayment of lease liabilities)
(Cash Flow From Operations + Interest Expense – Capital Expenditure – Repayment of lease liabilities)
Depending on your own valuation preference.
Investors should take note of the nature of the liabilities in their balance sheets. It is also worth noting that IFRS 16 might potentially increase the profit in the early stage of a lease, but the impact is not as drastic as it is on the balance sheet and cash flow statement.
So to Calculate FCF for Kimly, using the first method:
Net Cash From Operations = 86,921
Interest/Dividends Received = 1,002
Net Interest Paid = 4009
Capital Expenditure = 4802
Repayment of lease liabilities = 39738
86,921+ 1,002 – 4009 – 4802 – 39738 = SGD39,374
Using numbers provided by its FY2022 financial result:
- Increased transparency: The recognition of lease-related assets and liabilities on the balance sheet provides a clearer picture of a restaurant group’s financial position and its lease obligations as opposed to not knowing anything about its long-term liability pre-2019.
- Improved comparability: By standardizing the accounting treatment for leases, (grouping financial leases and operating leases together) IFRS 16 enables better comparison between companies, regardless of their lease structures.
- Financial ratios: The changes in the balance sheet, income statement, and cash flow statement may impact key financial ratios, such as the debt-to-equity ratio, return on assets, and operating margin. Investors and analysts need to be aware of these changes when evaluating a business’s financial performance. And it will confuse non-accounting financial users.
In summary, IFRS 16 has brought significant changes to lease accounting, affecting the way lease-heavy industries report their lease arrangements and impacting various financial statement items.
Although this new standard aims to improve transparency and comparability in financial reporting, it also complicates fundamental analysis for non-accountants. The new standard requires a thorough understanding of its implications to analyze the financial performance of lease-heavy industries accurately, which is drastically different from the pre-2019 IFRS standard.
Once again, this article is a guest post and was originally posted on @vincentwong ‘s profile on InvestingNote.
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