Joab is a regular visitor and commentator on my Insights blog and he’s a Value.able PHD graduate. Joab has put together an elegant summary of the impact – on retailers particularly – from the proposed changes to accounting standards for reporting lease liabilities to better reflect the contingent liability that is an operating lease.
No need to thank Joab. He’s delighted to help and I am delighted he went to the very great effort and time to contribute.
Why are the changes important? The impact of a bigger asset and a bigger liability will have no change on equity, but when you compare a bigger debt to the same equity, you will get a higher Debt to Equity figure. This will impact my Montgomery Quality Rating (MQRs) next year.
So here are Joab’s thoughts (with the community’s thanks):
Current State:
A draft proposal on accounting standard for leases was issued recently. This proposal could still be subjected to change as it is not yet finalised. That said, the principle of what it is trying to achieve is not expected to change.
Estimated timing:
Target date is to issue a finalised standard in 2011.
Key changes:
The information below focuses on the lessee’s perspective and has been simplified to highlight key impacts.
1. Operating leases will be on balance sheet as a lease liability (there will no longer be a distinction between operating and finance leases);
2. A corresponding asset will be recognised, separately on balance sheet, which offsets the operating lease liability;
3. Rent expenses will be replaced with depreciation and interest expenses;
4. Operating cash flow will no longer include cash outflow on rent. Instead, rental cash flow will be in the Financing Activities category as ‘Principal and Interest repayment’.
The table below compares the current and the new accounting rules on the financial statements.
Standard setters are open to feedback before end of this year.
Key Impacts:
– Financial ratios on gearing will suffer with more debt on balance sheet. For example: debt/ equity ratio, gearing ratio, interest cover ratio.
– Cash flow from operating activities will improve because rent will be presented in financing activities
– EBIT or EBITDA will improve as rent expense is replaced with depreciation and interest.
– Operating earnings will have a slightly different profile. Rentals expenses will no longer be a straight line expense.
Using JB Hi-Fi as an example
Note:
– I have excluded discounting on Operating lease commitment to simplify the calculation
– Debt/ Equity = Debt / Equity
– Net Gearing = (Debt – cash) / (Debt + Equity)
Posted by Roger Montgomery, on behalf of Joab, 29 October 2010.
