At long last, a company’s lease obligations – formerly buried in the back of the footnotes of the financial statements – are moving front and centre onto the balance sheet, as a new leasing standard goes into effect for both US GAAP and IFRS companies effective 1 January 2019. That’s just around the corner as the first quarter and half yearly results are set to be published in short order.
What’s changing? The short answer is that previously invisible leverage from leasing activities will now become visible, as all lease obligations will be presented as a liability on the balance sheet, offset by a “right of use asset,” representing the right to use the leased asset. Every company globally must recognise their lease obligations on the balance sheet. The size of the impact will depend on the nature of a company’s leasing arrangements.
CFA Institute has long advocated for recognition of lease obligations on the balance sheet because investors have been estimating and adjusting for this liability for decades. And, while the measurement methodology does not incorporate our preferred method of reflecting current market conditions, we generally view this change in accounting as a development that reflects how investors assess this leverage.
CFA Institute, like many others, have worked with standard setters on this new rule for the last decade. Because US GAAP and IFRS have decided on different solutions and transition methods, investors need to carefully consider the impacts of the new standards on the companies in which they invest. We thought it was important to help investors navigate the changes ahead. To that end, we have prepared a guide to help investors understand the change they are about to witness. Our paper, Leases What Investors Need to Know About the New Standard, provides the top ten considerations for investors as they evaluate the impact of the change to the new standard. Because the most significant change – and the greatest comparability challenges arise from lessee accounting, which has a broader impact for investors, this report focuses only on lessee accounting.
We have focused on top 10 considerations including:
- The Basics – Helping investors understand the basics of the new US GAAP and IFRS standards and their differences.
- Transition Methods – Explaining the methods and implications of transitioning to the new standards under US GAAP and IFRS – as well as the comparability challenge brought about by the differing methods.
- Transition Impact Disclosures – The transition disclosures to expect, some examples to illustrate, and how investors should evaluate the transition impact.
- Financial Statement Captions – The implications, and differences, of the new US GAAP and IFRS standard on financial statement captions. Including a quick illustration for those analytically inclined to visualise the effects and differences of the new standard on the income statement.
- Non-GAAP Measures – The implications of the different US GAAP and IFRS treatment of leases on the most notable non-GAAP measures. Most importantly, alerting investors to the fact that net income will likely be lower for IFRS companies while measures of operating income such as EBITDA and EBIT will be higher than the past and relative to US GAAP companies.
- Cash – Explaining how cash doesn’t change, but the statement of cash flows will change, for IFRS companies.
- Ratios – An analysis of the implications, and differences, of the US GAAP and IFRS standard on solvency, liquidity, profitability, earnings per share, return on equity, performance and coverage ratios. The comparability challenges abound and investors need to understand them.
- Disclosures – Why disclosures are more important than ever to investors now that the lease liabilities are measured in the financial statements. Considerations for investors as they analyse these new liabilities and value the company.
- Industries Impacted – A quantitative analysis of those companies in the S&P 500 expected to be most significantly impacted.Spoiler: retail, transports and some sleepers.
- Market Expectations – Consideration of how the market might react to the newly visible leverage.
Investors have long been aware of the hidden leverage in many sectors such as the retailing industry that arises from lease obligations. The devil is in the details, and so it is critical that investors understand these details. The CFA Institute paper is designed to help investors get beneath the headline numbers so they can properly analyse companies across differing accounting standards and over time. Each section has been created for investors to dip in and out of and consider the issues most important to them. Over the coming days, we will highlight the specific takeaways from each section.