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  1. #1
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    Default Leases and IFRS16

    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.

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    Last edited by Snoopy; 30-07-2021 at 07:14 PM.
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  2. #2
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    Default Effect on EBIT/I

    Quote Originally Posted by Snoopy View Post
    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?

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    Last edited by Snoopy; 14-01-2022 at 08:16 PM.
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  3. #3
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    Default EBIT/I for Chorus for FY2020 using method 1

    Quote Originally Posted by Snoopy View Post
    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)

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    Last edited by Snoopy; 17-01-2022 at 03:36 PM.
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    Default EBIT/I for Chorus for FY2020 using method 2

    Quote Originally Posted by Snoopy View Post
    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
    Last edited by Snoopy; 30-07-2021 at 09:28 PM.
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  5. #5
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    Angry EBIT/I for Chorus for HY2021 using method 1

    Quote Originally Posted by Snoopy View Post
    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/tele...nsidered-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
    Last edited by Snoopy; 31-07-2021 at 10:24 AM.
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    Default

    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
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  7. #7
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    Default

    Quote Originally Posted by Snoopy View 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.
    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
    Last edited by Snoopy; 31-07-2021 at 10:42 AM.
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    Quote Originally Posted by winner69 View Post
    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?

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  9. #9
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    Quote Originally Posted by winner69 View Post
    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.

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  10. #10
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    Default

    Quote Originally Posted by Snoopy View Post
    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/Down...204/291769.pdf

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

    SNOOPY
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