Hi all,
I've been following a stock with a substantial real estate holding (IWG, who lease office space), and with the transition to IFRS 16 their finances now look far bleaker than before as the new accounting method takes leases into account. I won't claim to understand the intricacies of the change, but wondered if anyone knew what the implications of this are and how large/small a dose of salt should be taken when reviewing their balance sheet in the context of the new method?
Cheers
Ross
Hi Ross,
There has actually been quite a lot of discussion on this over the last year or so, but not in one single place - so it's quite hard to track down where the meatier discussions were.
It's fair to say that opinions (including mine) have often been quite polarised on the subject, so I'll try to give a "neutral" read-out.
IFRS 16 relates to leases or rental agreements.
Prior to IFRS 16, rental costs were expensed as they became due and so just formed a simple component of operating expenses.
Often these rental aggreements have a minimum term, so the renter is obliged to continue to pay the rent for X years regardless of whether they want to continue using the item or property. In this past this forward obligation was not directly reflected in the accounts.
You could generally trawl through the notes to the accoutns and find the scale of the obligation. This is quite important to understand as many retailers have suffered from long term rental agreements on their stores at rates well above what a new tenant would be prepared to pay now.
IFRS 16 addresses this calculating the present value of those future rent obligations up until the point where there is a break-point or ability to cancel or renegotiate the rental.
This value then appears as a liability on the balance sheet, but to reflect the fact that the ability to contonue to use the premises (for example) in future this liability is balance by an asset : "right of use".
The slightly contraversial element is that that this liability (to pay future rent) is treated as debt and the rental actually paid is split into a notional interest payment on that debt and a notional repayment of the principal debt.
At the same time because (each year) the length of time the company is allowed to continue to use the property is reduced by one year, the balancing asset is depreciated.
Previously rent was and operating expense.
Now, the depreciation of the "right of use asset" is an operating expense, but the actual payment to the 'Landlord' is part interest and part repayment of debt.
Broadly there should be no real impact on profit (although the way the figures are calculated means there will be some slightlyu impact).
The more important impact however is that reported debt figure for the company is now higher than it would have been.
This can have profound impact on some of the key ratios, including those that drive the StockRanks - especially where a year on year change is being measured from an pre-IFRS16 figure to a post IFRS16 figure.
On the other hand a company that has long term rental commitments is essentially reporting its figures consistently with companies that instead took out a loan/mortgage to buy the assets they use.
I won't be so boring as to go too far into the rightsand wrongs of the approach, but it is important to recognise that certain financial ratios no longer mean what they used to mean - so screens and filters that used to work as an investment rationale, may no logner do so.
Pretty much nil.
The amount of cash they pay in rent to their "landlord" is exactly the same as it was.
Whilst some borrowing is covered by "covenants" which may mean a loan becomes immediately repayable in full if for example the profit to debt ratio falls below a given amount. However I think in most (probably all?) instances these covenants reflect the earnings to bank debt (not bank debt plus future lease liabilities).
In short I don't think you should conclude £IGW 's finances look bleaker - nothing has actually changed.
That said, I know nothing about the company (except that I recall I was unsuccesfully short Regus about a decade ago).
That's extremely helpful and comprehensive! Thanks a lot for the explanation and summary. I think a bit more due diligence is likely needed because, as you say, the StockRanks and other data points are skewed by IFRS 16. Will take a good look. Much appreciated
