Hiding in Plain Sight

“Hiding-in-plain-sight” is typically not a saying we would use to describe the accounting misperceptions we find when shorting stocks; uncovering these pearls usually requires much sleuthing. However, a new accounting rule might shed light on companies that were previously presenting their financial statements in a way that depicted a somewhat divergent representation compared to the reality of the business.

IFRS 16, the new accounting standard for leases, became effective for periods beginning on or after 1 January 2019. The rule eliminates the previous dual accounting model for lessees, which differentiated on-balance sheet finance leases and off-balance sheet operating leases. Companies are now required to record liabilities for long-term operating leases on the balance sheet, and recognize a corresponding “right-of-use”asset.

Almost all companies rely on leasing in some capacity as a means to obtain access to assets; it is a financing solution that obviates the need for large upfront cash outflows to purchase the assets. Firms that rely heavily on the leasing of assets –retailers, telecoms, and logistics providers, for example –will see material changes as off-balance sheet liabilities are shifted on-balance sheet.

Take the following table, which ranks the top 10 U.S. companies by the size of their leasing obligations. There are obviously enormous amounts previously recorded off-balance sheet that will now make their way onto firms’balance sheets.

Source: LeaseAccelerator; SEC Filings


Astute readers might point out that the changes are non-cash in nature, and shouldn’t affect the valuation. This is true to an extent, but the implications of the new leasing standard are arguably subtler. What IFRS 16 does is shine a light on the operating leases that were previously hiding off-balance sheet.

While this might simply be an accounting exercise for some firms, it may serve to elucidate the large (previously off-balance sheet, and perhaps out-of-mind) lease liabilities incurred by some firms. These lease liabilities have the effect of increasing the fixed cost base of a firm, thus exacerbating any operating leverage. This might be a non-issue when times are good. However, the increased operating leverage, particularly when combined with financial leverage, can be a pernicious cocktail when business conditions turn sour. The requirement under IFRS 16 to house these lease liabilities on-balance sheet is likely to make investors more cognizant of any excessive operating leverage in a business, and may serve to reduce the valuation multiple they are willing to ascribe to such a business, particularly during times of turmoil.

The precise mechanics of the IFRS 16 changes affect more than just the balance sheet; the income statement will also be impacted. Rent expense is replaced, and split between depreciation and interest expense. This results in a front-loaded lease expense (which will likely differ from the timing of cash outlays for the lease) which might reduce earnings and equity for some firms entering into a lease, compared to the accounting treatment under the previous IAS 16 rules.

The below table makes calculations around increases in debt and EBITDA for different industries as a result of IFRS 16.

Source: PWC

Many common financial ratios will be affected: gearing, asset turnover, interest coverage, to name a few, In theory these changes could precipitate breaches of loan covenants (unless a company has incorporated ‘frozen’ GAAP clauses in its debt covenants, which serves to protect companies from changes in accounting standards) or have credit rating implications. Right now the precise ramifications of the rule on firms that depend heavily on operating leases is unclear, but it’s certainly possible that the changes catalyze broader behavioural changes around how investors view these firms.

Montaka is short the shares of Walmart (NYSE:WMT)


George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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