SIF Folio: IFRS 16 Hits My Screen. What’s Changing And What Should I Do?

8th Oct '19 by Roland Head

9 comments 2523 reads

My article last week triggered some animated discussion about the implications of the new IFRS 16 lease accounting rules.

The company under discussion was small cap packaging group Macfarlane, whose reported net debt on Stockopedia has risen from £13.3m to £44.8m in six months. This was largely due to the new rules, not to a big increase in borrowing.

Small cap editor Paul Scott also gave his verdict on the IFRS 16 rules last week, generating a very lively comment thread.

Why the excitement?

Animated discussion and lease accounting aren’t usually words you’ll find in the same sentence. But IFRS 16 seems to have given rise to some strong views on both sides of the fence.

One of the points raised by subscriber Gromley in both my piece and Paul’s was that IFRS 16 is likely to cause disruption to anyone who uses stock screens and algorithms to pick shares.

The Macfarlane example above shows why. In many cases, IFRS 16 accounts will show a significant increase in reported net debt, even when actual debt is unchanged. (I’ll explain why in a moment.)

I use a stock screen to select shares for my Stock in Focus (SIF) fantasy fund. One of my screening rules measures the ratio of net debt to profit, so my investing will definitely be affected by IFRS 16.

This week I want to take a closer look at these new accounting rules and consider what changes I’ll need to make to maintain a consistent approach to stock selection.

Why was IFRS 16 required?

The failure of Debenhams earlier this year is an example of why it’s useful to understand lease obligations. The retailer’s estate of large and expensive stores on long leases was an early warning that it might be difficult to restructure the group without it going into administration.

Although much of this information was historically included in the footnotes of annual reports, it often lacked the detail and consistency needed for accurate appraisal. IFRS 16 is intended to address this.

Why leases matter: Let’s start with a quick overview of leasing. Companies can enter into two types of lease to acquire the use of an asset, such as a property or vehicle.

A finance lease transfers the risks and rewards of ownership to…

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john2

8th Oct '19

My first thought is that you could run your screen twice, once with the net debt rule enabled and once with it disabled. Hopefully that would reduce the number of companies for which you would have to analyse the gearing manually.

Gromley

Until then, I will disable my net debt rule and analyse the gearing of companies manually, staying loosely with the pre-IFRS 16 system. I plan to use the time to build a better understanding of IFRS 16 and its implications.

That sound sensible to me, although I might be biased given that having seen the title of your article that was what came to mind.

We can to and fro for ever about whether IFRS16 is "right" or "wrong" but we can certainly agree that it is different.

There are another couple of things I might suggest in the interim.

Earnings Yield % >= 8

By 'creating' extra debt IFRS16 also increases notional enterprise value and therefore suppresses Earning Yield. In the case of Macfarlane (LON:MACF) this is effect is c. 20%, but I can imagine a wide spread of impacts across different companies.

So personally I would disable this filter also and do a manual calculation.

Piotroski F-Score >= 6

If companies do not restate their PY numbers (MACF didn't) there is a pretty much automatic fail on the test "Is the company's long term debt reducing or stable?"

Potentially also a fail on "increasing its ability to pay short term debts" (again only if there is no PY restatement.

For me then,I would relax the automatic filter to >=4 and then manually assess whether the other two points have been earned.

Doing these manual assessments actually provides the ability to get a feel for the impact of the changes (although that is a bit irrelevant in the case of F-Score as this is only a transitory impact)

Just looking at the numbers as of today.

Your original screen throws up 10 candidates.

Remove the debt filter and it is still 10 currently.

Removing the Earnings Yield criteria brings the number up to 28 - that's quite surprising (to me) given that you also have PE filters.

Reducing the F-Score filter down to >= 4 , brings the number of qualifiers up to 42.

So that would be quite a lot of additional effort to adopt my ideas, but in reality I think you can probably get the time taken to analyse the differences down to about 5 minutes per stock using the StockReport. So that might be time worth investing?

Roland Head

Hi Gromley,

Thanks for your feedback. I agree that other measures than net debt will be affected, but when making changes I want to be careful to maintain the original intent of the screen ("affordable growth"). I don't want to allow stocks in that would not have qualified pre-IFRS 16.

Relaxing criteria such as earnings yield will increase the number of stocks which qualify, but in most cases this isn't specifically because of IFRS 16. Most of the extra stocks wouldn't have had an 8% earnings yield pre-IFRS 16 either.

I will be playing around with different ratios over the coming months to try and get a better feel for what needs to change, before I make any firm changes.

Cheers,

Roland

I probably didn't quite get my point across Roland.

What I meant was to relax the other two criteria, so that you can then test them manually taking out the IFRS16 impact to see if they would have passed the tests on the original basis.

32 extra stocks to manually check (as of today's number) and in fact probably less that the 5 minutes per stock to check I originally suggested as some of them can be rapidly dismissed due to not (yet) having an IFRS16 effect.

Ramsdens Holdings (LON:RFX) for example has an F-Score of 5 so qualifies for the looser screen, but none of the F-Score fails can be due to IFRS16 as they have yet to report under that standards.

Threepeat

Roland
Firstly I sympathise with you having to revise your criteria on a trial and error basis, but don't see what else you can do given the disparity of funding amongst the universe of companies.
Is it possible that the data contained in the stock report could show the IFRS 16 adjustments separately (note to Ed)??? I say this because having Stocko saves me the trouble of calculating gearing/ROE and ROCE manually. A quick glance is all that is required. Now this defeats the object of having it espially if looking for trends and comparatives
Alternatively all companies could report the effects of IFRS 16 on both P&L and balance sheet and all the relative metrics. But this may be like pulling teeth.
Here's hoping!

Steve

Never really understood the need for IFRS 16 as all the info was in the notes

Hi Gromley,

It's my fault, I didn't read your comments carefully enough! I do see your point.

One thing that does concern me is that fully removing the IFRS 16 impact may prove to be quite difficult in some cases. Although the effect on net debt will be crude and obvious, the effect on other metrics and ratios will be more subtle.

I suspect I may end up making a range of changes to my screen, to preserve the intent of my rules but to achieve this goal in a slightly different way -- if that makes sense.

For now, checking stocks as you suggest seems to make sense and should be a reasonable starting point.

Regards,

Roland

No problem Roland - I often skim read and miss things too.

If you are going to follow this path there are probably some bits of record keeping that can keep the workload down.

1. Don't review companies until their latest results are interims (or finals) for FY starting before 1-Jan-19.

I don't think there is a way to this through the screener, but it would be possible from other records.

I note this particularly because I noted that DFS Furniture (LON:DFS) have not yet adopted IFRS16 because their current FY started on 31st Dec 2018. So a company which could be amongst those most impacted by this (I am guessing) , will be amongst the very last to report under the new rules.

2. Do not recheck a company until they publish updated results.

Again, probably needs the maintenance of a separate list.

If it is helpful I have created my "relaxed" version of your screen HERE please feel free to use it or make your own copy.

Other than the relaxation / suspension of rules noted above, I have also added one rule Net Profit > 0. I noted that 3 stocks that show a loss in the last reporting period came up in my relaxed screen and it occurred to me that in theory your original screen could potentially throw up cash-rich (negative net debt) loss making companies.

This last modification brings my screen down to 39 and thus the number of stocks for manual investigation down to 29 - I've already done Ramsdens Holdings (LON:RFX) & DFS Furniture (LON:DFS) for you ;-)

Oh and just to add. I do agree it is complex to understand the precise impacts on screening in general but I am pretty sure that these are the only rules in your screen directly impacted.

In theory if the market "mis-reacts" to numbers presented under the new rules then momentum measures might be impacted in the short term, but that is unmeasurable, possibly a figment of my imagination and only transitory!

TMFMayn

13th Oct '19

Hi Roland

Thanks for covering this tricky subject.

"The Macfarlane figures above show us that the firm’s total assets rose by £29.7m as a result of IFRS 16. However, its current liabilities are only £6.0m higher. So the increase in capital employed is £23.7m (total assets minus current liabilities).

All else being equal, adding leased assets and financing obligations to a balance sheet will increase the amount of capital employed and reduce ROCE. This is because the value of fixed assets will rise to reflect the right-of-use assets on operating leases."

One issue here is the definition of capital employed.

You use “total assets minus current liabilities” as the ROCE denominator.

Capital employed ought to be shareholder equity plus debt added back — capital being a mix of equity and debt. Other adjustments can be made (financial leases, pension deficits, provisions etc), but that is the gist.

Investopedia says “Capital employed is the total amount of capital that a company has utilized in order to generate profits. It is the sum of shareholders' equity and debt liabilities. It can be simplified as total assets minus current liabilities.”

I do not agree the denominator can be “simplified as total assets minus current liabilities.”

If a business has debt classified in current liabilities, then such debt would be ignored using your calculation — even though such debt remains capital employed by the business. In reality, the debt is likely to be repaid with replacement longer term debt taken on — which would then be re-included in the denominator calculation.

“This is equivalent to the tangible asset that would be reported for a debt-funded/owned asset.”

The initial right of use asset is simply the value of the IFRS 16 lease liabilities plus some minor adjustments. MACF’s results give a proper definition: “Right‑of‑use assets comprise the initial measurement of the corresponding lease liability, lease payments made at, or before, the commencement day and any initial direct costs. They are subsequently measured at cost less accumulated depreciation and impairment losses.”

Maynard

14th Oct '19

Hi Maynard,

Thanks for your comments and for flagging up the risks implied by ignoring current debt!

In a healthy, well-run company, I would usually expect the current portion of debt to be significantly smaller than the non-current portion. Hence total assets minus current liabilities might be a tolerable approximation of capital employed.

If current debt was high enough to have a significant impact on ROCE, a more pressing question might be why the firm has so many near-term liabilities -- is it struggling to refinance them? This situation would certainly warrant a closer look, in my view.

Regards,

Roland

SIF Folio: IFRS 16 hits my screen. What’s changing and what should I do?

Why the excitement?

Why was IFRS 16 required?

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Roland Head

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