Leases and IFRS16

[Snoopy]

I can't recall a change in accounting rules that has caused more disruption to financial statements than IFRS16. The principle behind IFRS16 is to bring leased assets onto the company balance sheet. A lease becomes a 'right to use asset' on one side of the balance sheet offset by a 'lease payable liability' on the other. The 'right to use asset' is then amortised each year as annual lease payments are made, with a consummate reduction in 'lease payment liability'. In practice things are not quite as simple as this :-(.

The 'right to use asset' and the 'lease payment liability' are nominally of equal value, but they do not appear that way when listed on the company balance sheet. Each lease payable is measured as the 'present value' of all future lease payments, discounted back to the present at the incremental borrowing rate of the company. Lease costs are then recognised through 'lease interest expense' over the life of the lease.

SNOOPY

[Snoopy]

Lease costs are then recognised through 'lease interest expense' over the life of the lease.


I have a problem when assessing company solvency, which is a core part of any investment strategy. One way to assess whether a bank is generating enough income to pay its funders (think banks) is to look at the ratio: EBIT/I

'I' in the denominator is the net interest paid. However it is not clear to me that 'lease interest expense' is part of this. Before IFRS16, one of the most common forms of 'lease interest expense' was called 'rent'. 'Rent' was typically a business expense shoved in with the power bill and the wages bill in an 'operating expense bucket'. Post IFRS16, what was a 'day to day' expense has been pulled out of the overall 'operating expense bucket' and turned into a balance sheet item that did not exist before. Banks did not consider 'lease interest expense' as part of the overall company 'interest bill' because that 'lease interest expense' was generally owed to a different third party. Yet rent was taken account of by the banks indirectly, because rent reduces EBIT, the numerator of our 'ability to fund' assessment ratio. But under IFRS16, the treatment of 'rent'/'lease interest expense' as part of the debt assessment process is not clear to me.

None of this is about 'me' though, it is all about the banks. This suggests two alternative treatments for EBIT/I in the IFRS16 era.

1/ If 'lease interest payments' (sic, I can't help thinking of them as rent) have already been removed when calculating EBIT, then you should not include any lease interest payments in 'I' , the denominator of our ratio. To do so would mean you are accounting for the effect of rent twice, by:

a/ reducing earnings with rent AND
b/ converting rent into higher interest payment that must be serviced.

all at the same time. However

2/ If you remove 'rent' as a factor when calculating EBIT, because it is now classed under IFRS16 as a 'finance interest expense', then you will get a higher EBIT than before the change to IFRS16. In that situation, it would be appropriate to regard rent, now reported as a finance interest expense, as part of the denominator 'I'. Although doing it this way gives the company higher EBIT earnings, those higher EBIT earnings have a higher interest expense to cover. In this version of EBIT/I, the effect of 'rent' moves to the numerator.

The question I have is, under IFRS16, do I use method 1 or method 2 to calculate EBIT/I? Or do I have a choice which method I use?

SNOOPY

[Snoopy]

The question I have is, under IFRS16, do I use method 1 or method 2 to calculate EBIT/I? Or do I have a choice which method I use?


Sometimes the easiest way to make sense of these 'theoretical questions' is to do an example. I will do the calculation of "EBIT/I" for Chorus over the last reported year, FY2020.

AR2020 p27 tells us that :

1/ 'Other interest expense' includes $21m of 'lease interest', $5m of amortisation and a $1m restructuring expense due to interest rate swaps. That works out to a total of $27m.
2/ Now, if we go back to p24 of AR2020 and look under the 'expenditure commentary' we can see an entry 'Other $27m'. which ties in.
3/ Back a couple of pages further to p22 of AR2020. Right under the main 'Management Commentary' header you can see how the earnings are calculated. The first step is to take the 'operating revenue' and remove the 'operating expenses'. These are the same 'operating expenses' we have just looked at in a more detailed way on page 24.

These three steps show me that 'lease interest' has already been subtracted from profits. This means we should use 'Method 1' from my previous post when calculating EBIT/I.

EBIT is easy to find, it is listed as $246m on p22 of AR2020.

The slightly more tricky thing is figuring out the 'I' bit.

On page 27 of AR2020 we can see a 'Total Finance Expense' of $185m. But this is not the figure we use.

1/ Right at the top of the page we see 'Finance Income' of $12m that we have to offset against out finance expense.
2/ We must subtract from the 'net interest total' the $29m of 'CIP securities notional interest', because this is an accounting construction that is never actually paid (this is all explained on the Chorus thread, but for the purposes of this exercise please trust me on this point).
3/ Look further up the column and you will see the 'Other interest expense' of $27m that we have been discussing. That $27m has already been used in calculating EBIT. So we have to remove that from the interest bill as well , because if we did not we would, in effect, be counting it twice.
This means the 'Total Net Finance Expense' for our purposes is:

(-$12m + $185m) - $29m - $27m = $117m

So the obvious calculation of EBIT/I for Chorus for FY2020 is: $246m/$117m = 2.10 (using method 1)

SNOOPY

[Snoopy]

The calculation of EBIT/I for Chorus for FY2020 is: $246m/$117m = 2.10 (using method 1)


Now let's look at the alternative calculation method 2, where 'lease interest' (as part of 'Other Interest') is not taken into account when calculating EBIT.

EBIT now changes to $246m + $27m = $273m

With this iteration we have chosen not to take the lease interest into account as earnings. So instead we must include 'Other interest' as part of the total interest bill due by not subtracting it. This means the 'Total Net Finance Expense' for our purposes is now:

-$12m + $185m - $29m = $144m

So the calculation of EBIT/I for Chorus for FY2020 becomes: $273m/$144m = 1.89 (using method 2)

That isn't grossly different, except there is a 'rule of thumb' that says an EBIT/I ratio above 2 is passable, while anything below that is dodgy. So is 'method 1' or 'method 2' the better way of calculating this ratio? I don't know the answer. My solution is to curse IFRS16 and go to bed.

SNOOPY

[Snoopy]

The calculation of EBIT/I for Chorus for FY2020 is: $246m/$117m = 2.10 (using method 1)


The half year results for FY2021 are available. So let's see what EBIT/I did for the six months after EOFY2020. This isn't straightforward, because the disclosure at half year result time is less full than in the whole of year accounts.

EBIT = $114m vs $246m for the FY2020 full year (p5 HYR2021),
Net Finance Expense = $0m - $77m = -$77m vs $12m - $185m = $173m for the FY2020 full year. (p5 HYR2021)

A problem now arises because there is no breakdown of the finance expenses given for the half year. Given the comparative figures are given for the previous full year in the half year report, we have to assume there is no difference in the way the calculations have been made at HY2021 when compared with FY2020. That means if we work out our metric using the raw figures in HYR2021:

EBIT/I = $114m / $77m = 1.48

then we are 'double counting' the effect of 'lease interest payments'. Firstly because they have reduced EBIT in the numerator. Secondly because they have increased I in the denominator. You should do one or the other, but not both. My contention then is that there is insufficient information disclosed by Chorus to allow the calculation of EBIT/I over the half year period.

If we instead focus on the twelve month period comprising 2HY2020 and HY2021, then the calculation changes to this:

EBIT/I = (($246m-$134m) + $114m)/ (($185m - $95m) + $77m) = 1.35

This metric is also wrong, because it suffers from the same 'double counting' problem I have just described. If we look at the published information from third parties:

Morningstar:

https://www.morningstar.com/stocks/xnze/cnu/financials

lists the available EBIT/I for Chorus as 1.38 (close to my 2HY2020 + HY2021 figure in this post)

Simply Wall Street:

https://simplywall.st/stocks/nz/telecom/nzx-cnu/chorus-shares/news/chorus-nzsecnu-use-of-debt-could-be-considered-risky

lists the available EBIT/I for Chorus as 1.5 (close to my HY2021 figure in this post)

I submit that both of the 'Morningstar' and 'Simply Wall Street' EBIT/I figures are wrong, because they have both 'double counted' lease interest. I can't tell you what the correct figure is because there is insufficient disclosure by Chorus to allow us to work that out. Blame IFRS16 for this mess.

SNOOPY

[winner69]

Snoops - what’s the “Net outflow from leases” in Cash Flow Statement under Financing?

As an aside even Operating Cash Flow doesn’t include whst you and I call rent

[Snoopy]

I submit that both of the 'Morningstar' and 'Simply Wall Street' EBIT/I figures are wrong, because they have both 'double counted' lease interest. I can't tell you what the correct figure is because there is insufficient disclosure by Chorus to allow us to work that out. Blame IFRS16 for this mess.


As an exercise, so we can get an idea of how big the error might be, I will do the 'wrong' EBIT/I calculation for FY2020, where I 'double count' the effect of lease interest.

Using the raw figures for FY2020:

EBIT/I = $246m/ ($185m-$12m) =1.42

That is significantly different to the figure of 2.1 I got, without double counting. I would say IFRS16 has set up a trap for young players here. But looking at the published information, it looks like the trap has snared a few older players as well.

SNOOPY

[Snoopy]

Snoops - what’s the “Net outflow from leases” in Cash Flow Statement under Financing?


I see the $23m figure "Net outflow of leases" you are talking about (AR2020 p38). If you flip over the page (AR2020 p39) you will see the same figure again alternately described as a 'payment of lease liabilities'.

Now go to AR2020 p48 for a further breakdown of this. It seems that $15m is 'lease interest' and $8m is 'principal repayment' making up the total of $23m 'payment of lease liabilities' that appears in the Cashflow Statement. Yet for some reason the 'Interest on lease payable' in the income statement is different at $21m (confirmed in the text of AR2020 p27). What do you make of that?

SNOOPY

[Snoopy]

As an aside even Operating Cash Flow doesn’t include what you and I call rent.


Apparently it doesn't, although I do notice a discrepancy of $18m between 'Payments to suppliers and employees' being $329m in the cashflow statement (AR2020 p38), and 'Total Operating Expenses' of $311m (AR2020 p24). The latter also contains 'Rent and rates' of $13m which may be incorporated in the former. But it does look like 'rent' is now largely incorporated in the 'Cashflows from Financing Activities', the $23m you referred to earlier.

If the adoption of IFRS16 has lead to rent moving from an 'operating cashflow' to a 'financing cashflow', this does seem a perverse outcome, in terms of trying to understand the operating profitability of the business.

SNOOPY

[Snoopy]

I do notice a discrepancy of $18m between 'Payments to suppliers and employees' being $329m in the cashflow statement (AR2020 p38), and 'Total Operating Expenses' of $311m (AR2020 p24). The latter also contains 'Rent and rates' of $13m which may be incorporated in the former. But it does look like 'rent' is now largely incorporated in the 'Cashflows from Financing Activities', the $23m you referred to earlier.

If the adoption of IFRS16 has lead to rent moving from an 'operating cashflow' to a 'financing cashflow', this does seem a perverse outcome, in terms of trying to understand the operating profitability of the business.


Moving on from EBITDA/I, I noticed than most companies when adopting IFRS16, simply threw their hands in the air, and told us they would not try to restate profits from previous periods. They would then go on to make various 'one off ' adjustments to their balance sheets, without fully explaining the reasoning behind that, and then carry on as though IFRS16 had always existed. However, there was one prominent listed NZX company that did not do this - Spark. Spark went to the trouble of rewriting their FY2018 and FY2017 results to show the impact of IFRS16 (and also IFRS15 on realigning income and expenses to the appropriate time period) on their income statements of those two years.

https://investors.sparknz.co.nz/DownloadFile.axd?file=Announcements/NZX/20181204/291769.pdf

It is useful to have a fully worked actual example of the implementation of the IFRS16 rules such as this.

SNOOPY

[Snoopy]

Spark went to the trouble of rewriting their FY2018 and FY2017 results to show the impact of IFRS16 (and also IFRS15 on realigning income and expenses to the appropriate time period) on their income statements of those two years.

https://investors.sparknz.co.nz/DownloadFile.axd?file=Announcements/NZX/20181204/291769.pdf

It is useful to have a fully worked actual example of the implementation of the IFRS16 rules such as this.


Time for a bit more detail from the above referenced document. I will rewrite page 5 of that document in a non-Spark specific way.

1/ IFRS16 replaces 'NZIAS17 Leases' and removes the distinction between operating and finance leases. Similar to the current finance lease model, this results in the recognition of 'right of use' assets and related lease liability balances.
2/ As a result, rental payments for leases previously recorded in relation to operating leases - including corporate property leases, and customer equipment leases will move from being included in operating expenses (within EBITDA) to depreciation and and finance expenses outside of EBITDA.
3/ The impact on net earnings before income tax from an individual lease over its term is unchanged.
4/ However, the new standard results in a higher interest expense in early years and lower interest expense in the later years of a lease , compared to the previous straight line expenses profile of operating leases, similar to a 'table mortgage'.

What is a table mortgage?

From the NZ Finance Act of 1933
"the term table mortgage means a mortgage in which provision is made for the payment of interest and the repayment of principal by periodical installments, consisting partly of principal and partly of interest."

Impact on Reported Financials

1/ This results in the combined depreciation and interest expense, for any lease in the early years of its cycle, being higher than the operating expenses previously recognised. With long term corporate property leases, being in the early years of their lease period, both net earnings before tax and retained earnings subsequently decrease following application of IFRS16.
2/ There is a change in the treatment of leases where the reporting company acts as the intermediate party e.g. in a back-to back lease.

What is a back-to-back lease?

https://www.bdo.com.au/en-au/accounting-news/accounting-news-april-2019/sale-and-leaseback-arrangements

The seller receives a lump sum financing amount from the buyer on entering into the sale and leaseback transaction, and the seller (who is now the lessee), makes periodic payments to the buyer (who is now the lessor). Nevertheless the asset being sold and leased back, remains on the original sellers premises at all times.

In order to determine the appropriate accounting treatment under IFRS 16, the sale must first be assessed to determine whether it qualifies as a sale in accordance with the requirements of IFRS 15 (Revenue from Contracts with Customers). For the transaction to qualify as a sale the selling company must:

1/ Completely derecognise the asset in the books (remove from the accounts all traces of ownership) and apply lessee accounting requirements (set up a 'right of use asset' on the asset side of the balance sheet offset with a 'lease liability' on the debt side of the balance sheet).
2/ Measure the right-of-use asset as the retained portion of the previous carrying value. Then recognise a gain/loss on the rights transferred to the lessor.

IFRS 16 requires that any profit or loss on the sale side of the transaction from the seller-lessee’s perspective (and initial measurement of the asset purchased from the buyer-lessor’s perspective) to be determined by reference to the fair value of the asset, not the stated contractual sale price. Seller-lessees therefore need to determine the fair value of the asset in order to ensure they recognise the correct profit or loss on sale.

If it is determined that the fair value of the asset is less than, or greater than, the contractual sales price, the difference is accounted for by the lessee as an additional borrowing or a prepayment, respectively.

SNOOPY

[Snoopy]

Time to leave my 'safe printed documents' and 'wallow into the wilderness.'

I am turning my attention now to another actual example, 'Vital Communications Limited' (ticker NZX:VTL) and how they reported on making their IFRS16 transition in AR2020. I choose VTL as an example, because they are a smaller company that appear to have made a relatively clean transition. FY2020 for them began on 1st July 2019, and here are the changes to their opening balance sheet position. (Ref VTL AR2020 p18)



Right of Use Assets$27.969m


Deferred Tax Asset$7.831m


Deferred Tax Liability($7.831m)


Lease liabilities$27.969m



I like that. It shows that fiddling around reclassifying leases as assets has made no net difference to the balance sheet as a starting point, which is intuitively as it should be. (Although I am a little confused as to why the deferred tax liability is put in brackets (in accounting conventions, that normally means a negative value) yet the associated lease liability is not.)

From VTL AR2020 p24. "Deferred tax is measured at the tax rates that are expected to be applied to the temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date."

Now if you look at the above table: $27.969m x 0.28 (the NZ corporate tax rate) = $7.831m

So I get where that number come from. I can see that over time, a portion of the lease expenses will go into the statement of income, (so decreasing balance sheet company lease liabilities) coupled with an offsetting decrease in 'Right of use assets' on the other side of the ledger. Presumably the attached 'deferred tax liability' and 'deferred tax asset' go down as well at the same time? As far as I can tell the 'deferred tax assets' and 'deferred tax liabilities' look like accounting constructs that are never actually paid or refunded. And if I am right about that, why do 'deferred tax assets' and 'deferred tax liabilities' in relation to these lease arrangements even exist? Can anyone answer me that?

SNOOPY

[Ferg]

Now let's look at the alternative calculation method 2, where 'lease interest' (as part of 'Other Interest') is not taken into account when calculating EBIT.

EBIT now changes to $246m + $27m = $273m

With this iteration we have chosen not to take the lease interest into account as earnings.

Hello Snoopy

Why are you adding the lease interest to EBIT? I saw your explanation in the earlier post, but it does not make sense. I believe you are tying yourself in knots when the numbers we need are in the cashflow statement.*

How does one find the post I put up for you in another thread explaining IFR16?

I view the 2 options as being:
1) take the numbers as is, or
2) adjust the numbers back to the old method

Under method 1 you would use the published numbers - which I freely admit are "corked" due to the inclusion of lease interest and you lose the ability to compare to prior periods which did not have IFRS16.

Under method 2 we would adjust EBIT down (not up) for the rent payments (ie the total lease payments outflow from the cashflow statement, less GST = $23/1.12 = $20) and adjust EBIT up by the depreciation component of leased assets (i.e. $14), and would adjust "I" down for the lease elements only (i.e. $21).

EBIT: $246 - 20 + 14 = $240
I: $173 - $21 = $151
EBIT/I = 240 / 152 = 1.58

*Also, any differences between the P&L and cashflow will be due to accrual accounting.

FERG

[Snoopy]

How does one find the post I put up for you in another thread explaining IFR16?


As you have put it yourself, albeit not quite in these words: Seeking any rational explanation on the conceptualization and implementation of IFRS16 is a task that is, almost by definition, impossible.

However, to answer your search question, go to 'Search', then 'Advanced Search'. A box will pop up where you can put in a 'term to be searched for' (I put in 'IFRS16') then the name of the post author (I put in 'Ferg'). That search will then pull up a link to all posts that you have authored that mention IFRS16.

That lead me to your post 13827 on the Heartland thread.

https://www.sharetrader.co.nz/showthread.php?8425-HGH-Heartland-Group-Holdings&p=848304&viewfull=1#post848304

I don't know if that was the one you were looking for?

SNOOPY

[winner69]

If one is looking at EBIT comparisons I just take the lease components of the I and move them up to Operating Expenses or the like. To me that way better reflects the old fashioned premise of rent being an operating cost…..and I don’t need to rework history.

Re cash flow statements I take the lease bits out of the Financing bit and move them up to Operating Cash … again reflects old fashioned reality ….esp for stocks like retail with a high rent/lease cost.

[Snoopy]

Hello Snoopy
Why are you adding the lease interest to EBIT? I saw your explanation in the earlier post, but it does not make sense.


To contextualize this discussion, we are talking about the FY2020 results of Chorus and I am trying to decide whether to add lease interest payments to EBIT or not. The post you quote (post 4) is my 'method 2' calculation where I do add the lease interest to EBIT. The post you do not quote is my 'method 1' calculation (post 3) where I do not add the lease interest to EBIT. It sounds like you favour my 'method 1' (post 3) calculation, of my two options.

Although we are talking about EBIT, I am considering how that figure is useful in evaluating banking covenants - in particular EBIT/I.



I believe you are tying yourself in knots when the numbers we need are in the cashflow statement.*

I view the 2 options as being:
1) take the numbers as is,

Under method 1 you would use the published numbers - which I freely admit are "corked" due to the inclusion of lease interest and you lose the ability to compare to prior periods which did not have IFRS16.


OK under method 1, I just used the published figure of EBIT which is $246m (AR2020 p22). The contentious factor in doing this is that what used to be classed as 'rent' has now been moved to a 'finance expense' under 'Other interest expense' header of $27m (AR2020 p27). In the text further down that same page we find that $27m figure includes $21m of 'lease interest' (formerly called rent). I notice that in your own adjusted 'method 2' calculation (quoted further down this page), you have adjusted for this. But you did not adjust for the rest of the 'Other interest expense' (again refer to AR2020 p27) where $5m of 'amortisation arising from the difference between fair value and proceeds received from interest rate swaps' and $1m of 'one off expense in FY2020 for restructuring forward interest rate swaps'. Of course that $5m and $1m are not directly related to IFRS16, which may be why you did not mention them. But in the context of the EBIT/I banking covenant, I considered those one off charges that any bank would look through, which is why I added those back to the EBIT as well (my post 4).

However with the aim of keeping this discussion 'on topic' to IFRS16, I will forgo those other adjustments and go with your figure of $21m



or 2) adjust the numbers back to the old method

Under method 2 we would adjust EBIT down (not up) for the rent payments (ie the total lease payments outflow from the cashflow statement, less GST = $23/1.15 = $20)


I think you made a typo in that GST calculation (now corrected). When I corrected the GST rate from 12% to 15% it worked, giving the $20m figure you quoted.



and adjust EBIT up by the depreciation component of leased assets (i.e. $14),


OK I see that $14m 'right of use asset' depreciation, listed in the Depreciation & Amortisation break down in AR2020 on p26



and would adjust "I" down for the lease elements only (i.e. $21).


"lease interest of $21m" in the text in AR2020 p27, - gotcha



EBIT: $246 - 20 + 14 = $240
I: $173 - $21 = $152
EBIT/I = 240 / 152 = 1.58


OK this is where you and I have rather different adjusted EBIT calculations.

I hadn't considered depreciation before. Because as we were talking about EBIT, I had considered the 'D'epreciation' part of the EBITDA to EBIT calculation already dealt with. But now I see you are correct Ferg, because the 'depreciation of the lease liability' did not exist under the old accounting rules. So to make a comparison with previous years, you have to increase the EBIT by any depreciation that was not present and in fact did not even exist at all under the old accounting rules.

Under the new accounting rules, what were 'rent payments' (an operating cost) have turned into 'lease interest liabilities' (a finance cost). Under the new rules of EBIT, all financing costs are yet to be subtracted before NPAT is calculated. Under the old accounting rules the equivalent of 'lease interest liabilities' (the old 'rent') would have already come out of the EBIT figure. This means in consideration of interest payments only, that to convert the EBIT you see published in the annual accounts under IFRS16, back to the lower EBIT figure we would have seen under the old accounting rules, we have to subtract the 'lease interest liability' from the EBIT figure quoted. So it looks like you are right again Ferg. (note: Typo on your interest calculation corrected).

What slightly puzzles me is why you have chosen to reduce the interest bill by the 'lease interest liability' ($21m), yet reduced the EBIT figure by an interest figure derived from the cashflow statement ($20m). Shouldn't these two numbers be exactly the same?



*Also, any differences between the P&L and cashflow will be due to accrual accounting.

FERG

You refer to the difference between $21m of "lease interest" (AR2020 p27) and the 'net outflow from leases' of $23m in the cashflow statement (AR2020 p38) ?

SNOOPY

[Ferg]

Hi Snoopy

You have understood my post correctly and yes I ignored the other interest elements to just focus on IFRS16.

Thanks for picking up on the GST typo - that often happens when you don't look while using the keypad numbers (numbers out by 3 is very common in such situations).

Depreciation - your logic is correct, that's why we need to adjust for it.

This is where your interpretation is not quite correct:
"Under the new accounting rules, what were 'rent payments' (an operating cost) have turned into 'lease interest liabilities' (a finance cost)"

The old rent payments are NOT interest payments. The $20 was the old rent payment (after adjusting for GST given cash flow statements are usually GST inclusive), but the $21 is the new lease interest under accrual accounting (not cash). The fact they are close is a fluke.

The rent payments are now payments due on lease liabilities. (<- notice the word 'interest' is missing) These payments which reduce the lease liabilities may be more or less than the interest cost on those same liabilities, usually more but they can be less. The interest calculation on the lease is separate from the amount paid under the old rent method and will differ on most occasions but there may be the odd occasion where they match which would be a fluke. Keep in mind any changes in the PV of future payments due to a changed discount rate would, I believe, go through the interest line under IFRS liabilities, and appear in the P&L accordingly. They would then be part of any difference between cash flows and interest charges. This is why I was trying to find my old post that stepped you through all the journals - it was two below the one you quoted. This post explains the journals and you will see the old rent cash outflow differs to the interest charge:
https://www.sharetrader.co.nz/showthread.php?8425-HGH-Heartland-Group-Holdings&p=848564&viewfull=1#post848564

Lastly, the comment around accrual accounting was in response to your post #9 where you say:
"although I do notice a discrepancy of $18m between 'Payments to suppliers and employees' being $329m in the cashflow statement (AR2020 p38), and 'Total Operating Expenses' of $311m (AR2020 p24)"

Having differences between payments to suppliers and expenses per the P&L is extremely common - it would be rare to not have a difference. It's not what I would call discrepancy, rather it is there due to accrual accounting rules.

[Snoopy]

Time to eat a bit of 'humble pie' this evening and admit when I did my EBIT/I covenant calculation (post 4 on this thread) - where I adjusted for the effect of any 'lease interest deductions' (that are partially reflective of the old 'rent' charge under the old pre-IFRS16 accounting standard)- I got it wrong.

The 'wrong' calculation I have quoted below.....



Now let's look at the alternative calculation method 2, where 'lease interest' (as part of 'Other Interest') is not taken into account when calculating EBIT.

EBIT now changes to $246m + $27m = $273m

With this iteration we have chosen not to take the lease interest into account as earnings. So instead we must include 'Other interest' as part of the total interest bill due by not subtracting it. This means the 'Total Net Finance Expense' for our purposes is now:

-$12m + $185m - $29m = $144m

So the calculation of EBIT/I for Chorus for FY2020 becomes: $273m/$144m = 1.89 (using method 2)

That isn't grossly different, except there is a 'rule of thumb' that says an EBIT/I ratio above 2 is passable, while anything below that is dodgy. So is 'method 1' or 'method 2' the better way of calculating this ratio? I don't know the answer. My solution is to curse IFRS16 and go to bed.


.....while the changes I wish to introduce are summarized below (thanks to Ferg for pointing this stuff below out to me).



OK this is where you and I have rather different adjusted EBIT calculations.

I hadn't considered depreciation before. Because as we were talking about EBIT, I had considered the 'D'epreciation' part of the EBITDA to EBIT calculation already dealt with. But now I see you are correct Ferg, because the 'depreciation of the lease liability' did not exist under the old accounting rules. So to make a comparison with previous years, you have to increase the EBIT by any depreciation that was not present and in fact did not even exist at all under the old accounting rules.

Under the new accounting rules, what were 'rent payments' (an operating cost) have turned into <added> 'lease liabilities' (an operating cost) and </added> 'lease interest liabilities' (a finance cost). Under the new rules of EBIT, all financing costs are yet to be subtracted before NPAT is calculated. Under the old accounting rules the equivalent of 'lease interest liabilities', (<added> part of </added> the old 'rent') would have already come out of the EBIT figure. This means in consideration of interest payments only, that to convert the EBIT you see published in the annual accounts under IFRS16, back to the lower EBIT figure we would have seen under the old accounting rules, we have to subtract the 'lease interest liability' from the EBIT figure quoted. So it looks like you are right again Ferg.


So let's go through this 'step by step', adjusting EBIT back to what it was in the 'old days' (pre IFRS16 reporting standards), to make sure I don't 'stuff up' again.



Declared EBIT = $246m (AR2020 p22)


add 'Right of Use Asset' Depreciation + $14m (AR2020 p26) (Non existent asset under old regime, so not there to depreciate)


subtract 'Rent Paid' - $20m (AR2020 p38, $23m exGST) (post IFRS16 EBIT is not adjusted for the old 'rent' concept)


equalsAdjusted EBIT = $240m (Calculated)



Previously I had also added back a couple of one off interest charges




add 'Amortisation Loss' + $5m (AR2020 p47) (One off Swap reset reversed: difference between fair value and proceeds realised)


add 'Restructuring Loss' + $1m (AR2020 p47) (One off cost to restructure interest rate swaps reversed)




However, these are interest charges, not directly related to Covid-19. While they do produce a higher normalised profit at NPAT, they do not produce a higher profit at EBIT level. So I think, it is best to leave these changes out of my EBIT adjustment.

The interest calculation is therefore as follows:




Declared Interest Expense = $185m (AR2020 p47)


subtract Interest Income - $12m (AR2020 p27)


subtract 'Amortisation Loss' - $5m (AR2020 p47) (One off Swap reset reversed: difference between fair value and proceeds realised)


subtract 'Restructuring Loss' - $1m (AR2020 p47) (One off cost to restructure interest rate swaps reversed)


subtract 'CIP Notional Interest' - $29m (AR2020 p47) (This is an artificial accounting construct based on defined CIP construction and is never paid in practice)


equals Adjusted Net Interest Bill = $138m (Calculated)



So EBIT/I = $240m/$138m = 1.74

SNOOPY

[Snoopy]

This is where your interpretation is not quite correct:
"Under the new accounting rules, what were 'rent payments' (an operating cost) have turned into 'lease interest liabilities' (a finance cost)"

The old rent payments are NOT interest payments. The $20 was the old rent payment (after adjusting for GST given cash flow statements are usually GST inclusive), but the $21 is the new lease interest under accrual accounting (not cash). The fact they are close is a fluke.

The rent payments are now payments due on lease liabilities. (<- notice the word 'interest' is missing) These payments which reduce the lease liabilities may be more or less than the interest cost on those same liabilities, usually more but they can be less. The interest calculation on the lease is separate from the amount paid under the old rent method and will differ on most occasions but there may be the odd occasion where they match which would be a fluke.


Right, I am a bit slow with this. But I have FINALLY figured out what you and Winner are on about grabbing the 'rent' from the cashflow statement. I was all tied up with comparing 'pre-IFRS16' and 'post-IFRS16' when it suddenly hit me that the whole IFRS16 thing is nothing more than accounting construct that has relevance to how a business reports, but little relevance to how a business operates day to day.

When you said Ferg
"The $20 was the old rent payment (after adjusting for GST given cash flow statements are usually GST inclusive)",

the message you were trying to communicate to me was that this $20m is the 'current annual rent payment' (net of GST), as it would have been reported had the old pre-IFRS16 standards still been in place. Why? Because landlords don't care about IFRS16. They just want their rent money, paid in cash, And this 'net outflow from leases' entry in the cashflow statement of $23m (or $23m/1.15 = $20m rent net of GST) is that rent money, paid in cash.

Over the course of a lease:

1/ the multi-year cashflow reported 'rent payments' and
2/ the multi-year accounting standard reported 'lease liabilities' and associated 'lease interest liabilities'

both add up to the same total. But because of the way IFRS16 demands these payments are reported, on a year by year basis 'Total 1/' generally does not equal 'Total 2/' for any given year.

IFRS16 requires rent contracts to be capitalised as a 'Right to Occupy Asset' with an offsetting 'Lease Liability' to appear on either side of the balance sheet. However, a rent contract over many years means that the 'Lease Liability' must be reflected on the balance sheet taking into account a 'time value of money' discount. This is because rent money due in ten years time (say) has a lesser present day value than rent due 'this year'. Doing this upsets the offsetting balance sheet effect of the 'Right to Occupy Asset' and the 'Lease Liability' (these two constructs are no longer equal). So to fix this on the balance sheet, we introduce a third artificial liability construct called the 'Lease Interest Liabillity'.

As far as day to day running of the business goes, rent is paid as before. But as for reporting that rent payment according to IFRS16, the accounts show that a 'lease liability' and an associated 'lease interest liability' has been paid. And because of the discounting rate applied to this lease liability, the sum of that 'lease liability expense' and the associated 'lease interest liability expense' will NOT in general equal the actual rent paid in any particular year.

Ferg, you say the fact that quantum of the 'old' (meaning under the old standard) rent payment' at $20m and the 'Interest on lease payable' of $21m (AR2020 p48) being similar is a fluke. I offer an alternative assessment that -to the contrary- you would expect these two figures to be similar, because they are really alternative measures of the same thing, (with a slight valuation time shift in one of the measures).

"The rent payments are now payments due on lease liabilities. (<- notice the word 'interest' is missing) These payments which reduce the lease liabilities may be more or less than the interest cost on those same liabilities, usually more but they can be less."

The payments referred to in the above sentence are a result of the balance sheet discounting of the lease liabilities, which seems to lead to the total 'lease liability expense' being greater in the initial years of the lease contract, in comparison with the latter years of the lease contract. I don't really understand the mechanics of that, but this seems to be what is commonly reported. So while the above stated sentence is true, a more detailed expectation would be that on any particular lease, annual lease expenses would start out high (i.e.higher than the annual rent) and then reduce towards the end of the lease term (to below the annual rent). The net effect being that over several years rent contracts are slightly 'front loaded' when reported under IFRS16.

"The interest calculation on the lease is separate from the amount paid under the old rent method and will differ on most occasions but there may be the odd occasion where they match, which would be a fluke."

I found my self confused by the above sentence because 'interest' has two meanings. The first meaning is that if you have an 'interest' in an asset, then you have an ownership stake in that asset. The second meaning is that if you are paying 'interest' on an asset, this is a regular payment (to a lender that allows you to gain ownership of an asset via a small capital deposit). Now I am sure that when you wrote that sentence Ferg, you had a clear idea of what you were trying to communicate. But from where I sit, the phrase 'interest calculation' could refer to either meaning. At this point you will say I am playing 'semantics'. But without clarification of what 'interest' means, (or indeed what a 'fluke' means in this context), I genuinely do not understand what you are talking about, or what point you are trying to explain.

SNOOPY

[Ferg]

You are onto it Snoopy and got it mostly right until the very end.

That sentence that confused you was just reiterating a previous sentence. In hindsight I was not 100% clear with the phrase "The interest calculation on the lease" where if you take the word "interest" out of the sentence and lose the context, then it can have 2 meanings. It was a numerical interest charge calculation on a lease loan, not a legal interest in a leased asset. In other words "The numerical calculation of the interest charge on the lease liability is separate from the amounts paid under the old rent method". The concept of calculating interest on the lease liability here is similar to the concept of calculating the interest component of loan repayments on a mortgage. I don't want to get into more details here because I think we will get bogged down.

But, what I was trying to convey was the method of calculating the rent payments (under the old method they were rent in the P&L, but now appear in the cashflow statement which you have demonstrated you understand, and are easily calculated by looking at the dollars that came out of ones bank account over the reporting period) are different to the calculation of the interest charges on the lease liability which appears in the P&L (which involves the use of discount rates, a schedule of payments in future reporting periods and a slide rule).

In other words, the method for determining and/or collating the schedule of rent payments (which is per the lease agreement) differs to the method of calculating the interest charge pertaining to the lease liability (per the IFRS16 rules). Given the two values come from two differing starting points and/or work streams, then the chance of them being identical is small. And if the chance of something occurring is small, but it does actually occur, then that is what I call a "fluke".

Lastly, the concept of the rent payment amounts almost always being higher than the interest charge is like the concept of a table mortgage - the total $ amount of repayments in any period will always be more than the total $ interest charges over that same period, despite the front end loading of interest charges. Some of the monthly payment is principal, and some is interest. Logically, if the monthly interest amount exceeds the total monthly repayment amount, then the balance would increase and the mortgage would never be repaid. Hence the total payments will always exceed the total interest charges for a mortgage (unless one defaults of course).

The odd occasion where interest charges on a lease liability may exceed the total lease liability payments (over a single reporting period) is if a lower discount rate is used to revalue the lease liability balance upwards during that reporting period. This results in an additional interest charge and a corresponding increase in the overall lease liability (i.e. debit lease interest in the P&L, credit lease liability in the Balance Sheet) and, for that reporting period, the interest charge in the P&L could exceed the total payments made per the cashflow. How can this be you might ask over a full lease term? How can the total cost of interest over the lifetime of a lease be less than the total cost of the payments over the term of a lease? That is because interest is not the only cost; there is a 2nd cost that also hits the P&L - that is the depreciation on the leased asset. I refer you to the HGH link - you cannot ignore the depreciation when looking at the cost in the P&L.

[Snoopy]

Under method 2 we would adjust EBIT down (not up) for the rent payments (ie the total lease payments outflow from the cashflow statement, less GST = $23/1.12 = $20) and adjust EBIT up by the depreciation component of leased assets (i.e. $14), and would adjust "I" down for the lease elements only (i.e. $21).

EBIT: $246 - 20 + 14 = $240
I: $173 - $21 = $152
EBIT/I = 240 / 152 = 1.58




What slightly puzzles me is why you have chosen to reduce the interest bill by the 'lease interest liability' ($21m), yet reduced the EBIT figure by an interest figure derived from the cashflow statement ($20m). Shouldn't these two numbers be exactly the same?


To answer my own question.....

$21m is taken off the interest bill. This is because working from the income statement, and being referenced back to Note 4, the interest bill is broken down in great detail. There is an item of $27m covering 'Other Interest Expense' from the expense table and the text below this table shows this $27m includes $21m of 'lease interest expense'. Thus this $21m is directly related to the reporting policy of adopting IFRS16. Before adopting IFRS16 this part of the interest bill did not exist.

EBIT means Earnings Before Interest and Tax. Pre-IFRS16 EBIT considered all expenses prior to 'Interest' and 'Tax' being deducted. 'All expenses' included the old 'rent' which is represented on the cashflow statement as a 'net outflow of leases' on the cashflow statement of $23m (including GST) which translates to ($23m/1.15=) $20m before GST (commercial rent payments, unlike rent on suburban day to day household properties normally include GST) .

However, because the reported 'lease interest expense' in any year does not necessarily line up with the 'rent' being paid under the old pre-IFRS16 system, it is necessary to adjust the 'total interest bill' and the 'EBIT' by different amounts.

SNOOPY

[Ferg]

Spot on.

Although I have just seen a typo in my calculation. That second step should read 173 - 51 = 152, thankfully I carried the correct figure through to step 3.

[Snoopy]

If one is looking at EBIT comparisons I just take the lease components of the I and move them up to Operating Expenses or the like. To me that way better reflects the old fashioned premise of rent being an operating cost…..and I don’t need to rework history.


And the depreciation of IFRS16 created lease liabilities? How does that fit into your adjusted EBIT picture?

SNOOPY

[winner69]

And the depreciation of IFRS16 created lease liabilities? How does that fit into your adjusted EBIT picture?

SNOOPY

Included in Depreciation and Line - so already part of EBIT

That's one reason why EBITDA is a bit of a nonsense these days but you can adjust EBITDA by allowing for depreciation/amortisation of leases

[Snoopy]

And the depreciation of IFRS16 created lease liabilities? How does that fit into your adjusted EBIT picture?




Included in Depreciation and Line - so already part of EBIT


I get that Depreciation and Amortisation have already been removed in transforming EBITDA to EBIT in the FY2020 accounts. However, the depreciation removed in the FY2020 accounts, during the EBITDA to EBIT calculation, as printed, includes the 'depreciation of the right to occupy' which did not exist before IFRS16. IOW the depreciation pre-IFRS16 and depreciation post-IFRS16 are not the same thing. So if you are converting the figures in the FY2020 report back to a pre-IFRS16 comparison figure, don't you need to add the 'depreciation of the right to occupy', the difference between depreciation pre-IFRS16 and depreciation post IFRS16 (the new increment of depreciation that did not exist before), back?

SNOOPY

[winner69]

I get that Depreciation and Amortisation have already been removed in transforming EBITDA to EBIT in the FY2020 accounts. However, the depreciation removed in the FY2020 accounts, during the EBITDA to EBIT calculation, as printed, includes the 'depreciation of the right to occupy' which did not exist before IFRS16. IOW the depreciation pre-IFRS16 and depreciation post-IFRS16 are not the same thing. So if you are converting the figures in the FY2020 report back to a pre-IFRS16 comparison figure, don't you need to add the 'depreciation of the right to occupy', the difference between depreciation pre-IFRS16 and depreciation post IFRS16 (the new increment of depreciation that did not exist before), back?

SNOOPY

Sorry Snoops, you’ve lost me now

But own up to talking on a general basis …whereas you and Ferg talking about Chorus …yes?

And confess I haven’t been following the detail of that conversation

[Snoopy]

Sorry Snoops, you’ve lost me now

But own up to talking on a general basis …whereas you and Ferg talking about Chorus …yes?

And confess I haven’t been following the detail of that conversation


Yes we have been discussing Chorus, as an example. But the particular post you responded to of mine did not mention Chorus. And that is because I was commenting on a general principal of IFRS16, with no reference to Chorus. Namely that the calculation of depreciation pre IFRS16 is different to the calculation of depreciation post IFRS16, because IFRS16 introduces a new item to depreciate the 'Right of Use of Assets' that was not there before.

Thus claiming that you don't have to worry about the 'D' bit in EBIT, because the 'D' bit has been subtracted out as EBITDA transformed to EBIT is not giving the full picture. Because the D bit you subtracted out is larger than it was before. And that gives you a comparative EBIT that you are comparing with earlier pre-IFRS16 EBIT figures, that is smaller than it should be..

Far from being a curiosity connected to Chorus, this point relates to every company that adopts IRFS16 and has a lease (and a consequent 'Right of use asset' on the balance sheet).

SNOOPY

[Ferg]

Quite right Snoopy. It's almost a pre and post IFRS16 world. I fear we can't keep adjusting forever.

[Snoopy]

Quite right Snoopy. It's almost a pre and post IFRS16 world. I fear we can't keep adjusting forever.

Ah but we can, and perhaps the banks will? Because as every banker knows, there is no need to worry about the value of the 'lease liability' on the balance sheet, because it is balanced out by the equally large 'right to occupy' asset on the other side of the balance sheet. So no doubt every banker worth hiser financial pay grade, will continue to look through the lease liability debt, and any consequent lease liability interest bill, when considering how much money they can lend a company?

The alternative suggestion of what we should be doing from a pre IFRS16 perspective can be found here:

https://www.whitecase.com/publications/alert/ifrs-16-are-you-ready

"Rather than treating IFRS 16 as the elephant in the room, it would be advisable for borrowers and lenders, particularly for new transactions, to embrace IFRS 16 in original financial statements and the related base case models, with financial covenants, thresholds, baskets and ratios being adjusted accordingly."

Now we have arrived in the IFRS16 world, has anything been done? Because if the answer is no,

e.g. used on this thread , Chorus over FY2020:

Case (a) Pre IFRS16: EBIT/1= 2.1 (refer post 3)
Case (b) Post IFRS16: EBIT/1= 1.7 (refer post 18)

then the banks have just agreed to be more generous with their lending policies, with a proportionate increased in lending risk for bank shareholders that they have not been told about!

SNOOPY

[kiora]

"“Buyers will start accepting overoptimistic accounting adjustments and financial forecasts to justify taking on high levels of debt.”

This is another more subjective one, but ask yourself this; how many times have you seen “EBITDA” or “Adjusted EBITDA” in company accounts recently?"
https://www.livewiremarkets.com/wires/how-to-tell-when-the-market-s-bottomed

[winner69]

"“Buyers will start accepting overoptimistic accounting adjustments and financial forecasts to justify taking on high levels of debt.”

This is another more subjective one, but ask yourself this; how many times have you seen “EBITDA” or “Adjusted EBITDA” in company accounts recently?"
https://www.livewiremarkets.com/wires/how-to-tell-when-the-market-s-bottomed

Put this on the NZX50 thread --- its good