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.

5d9c538176773S1.png

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…

Unlock the rest of this Article in 15 seconds

or Unlock with your email

Already have an account?
Login here