Did you notice that in recent quarters, companies have been reporting better EBITDA (Earnings before Interest, Tax, Depreciation & Amortisation) and Free Cashflow figures? Do not be happy too soon, as the improvements could merely be due to a change in accounting rule for leases.

Before this year, companies that lease properties, equipment, etc. could choose to treat the leases as operating leases if they meet certain conditions and expense the rents as they fall due. There are no assets and liabilities on the balance sheet associated with these operating leases. This poses a problem when comparing against companies that own the properties and/or equipment. In reality, is a company that leases property very different from another that owns a leasehold property? In terms of the rights to use the property, the differences are small, but financially, the differences can be quite significant. On the balance sheet, such property-owning companies would have more assets and probably more loans to fund these assets. On the income statement, these companies would not have to pay any rent but would have higher depreciation and probably higher interest expenses.

Starting from this year, all companies have to adopt the Singapore Financial Reporting Standards (International) SFRS(I) 16 on Leases, which standardise the way companies report leases on their financial statements. Companies can no longer choose to treat their leases as operating leases and expense the rents. Companies have to treat their leases as financial leases and include the asset as a Right-of-Use (ROU) asset and a corresponding lease liability on the balance sheet. The lease liability is the present value of all future lease payments. At the start of the lease period, both the ROU asset and lease liability must match and balance out each other.

Companies only have the rights to use the ROU asset for the duration of the lease. Hence, at the end of the lease period, both the ROU asset and lease liability have to be reduced to zero. ROU asset is reduced to zero through depreciation. Lease liability is reduced to zero through amortisation. This is similar to loan repayment, in which the remaining loan amount each year is increased slightly by the interest expense, but reduced by a larger amount by the loan repayment. Both depreciation and amortisation affect the income and cashflow statements. It would be clearer to illustrate the changes using a company's actual financial statements.

The example used here is Hour Glass, which is a watch retailer that leases properties to operate its shops. Its business is generally stable, making year-to-year comparison valid. Furthermore, it separates out ROU assets and depreciation while most companies combine them with Property, Plant and Equipment (PPE), hence, allowing a clearer view of the effects of SFRS(I) 16. Companies should be encouraged to adopt the same practice.

Fig. 1 below shows the balance sheet for Hour Glass in 1Q2019.

Hour Glass adopted SFRS(I) 16 starting from this Financial Year (FY), which began in Apr 2019. It added ROU assets of $113.8M and corresponding lease liabilities of $116.1M. The ROU assets are nearly twice as much as Property, Plant and Equipment (PPE) which amounts to $58.7M. This shows that the value of rental properties could be as much as or even more significant than the leasehold properties that the companies own. Note that not all companies report ROU assets separately; some companies report them together with PPE.

Fig. 2 below shows the income statement for 1Q2019.

On the income statement, rental expenses are reduced significantly from $7.6M in 1Q2018 to $1.2M in 1Q2019. On the other hand, there is additional depreciation of $6.9M on the ROU assets. Finance cost is also higher by $0.5M to account for the interest expense incurred on the lease liabilities. Assuming all other factors remain constant, the net effect of these factors due to adoption of SFRS(I) 16 is a reduction of $1.1M in operating profit for Hour Glass in 1Q2019.

However, if you compute EBITDA, EBITDA computation excludes depreciation and interest, among others. Changes in depreciation and interest do not affect EBITDA. Hence, only the change in rental expenses affects EBITDA. Holding all other factors constant, EBITDA would have increased by $6.4M in 1Q2019. In 1Q2018, Hour Glass' EBITDA was $19.2M. The change in accounting rule for leases has increased Hour Glass' EBITDA by 33%!

Fig. 3 below shows the cashflow statement for 1Q2019.

For Cashflow from Operations (CFO), depreciation from ROU assets is added back to the operating profit. For Cashflow from Financing (CFF), payment of lease liabilities, i.e. rental expenses, is included. 

Previously, rental expenses would have been deducted when computing the operating profit which is used as the starting point to compute the CFO. The rental expenses have been mostly replaced by depreciation of ROU assets, but in computing the CFO, the depreciation of ROU assets is added back. Hence, the net effect is an increase in CFO, by an amount equivalent to the payment of lease liabilities, which is now moved to CFF. Holding all other factors constant, the net effect is an increase in CFO by $6.1M, or 53% from 1Q2018!

Free Cashflow (FCF) is generally computed as CFO minus capex. Since CFO increased by $6.1M, FCF would have increased by an equivalent amount. Assuming no change in capex, FCF for Hour Glass in 1Q2019 would have increased by 68% simply from a change in accounting rule!

The above discussion summarises the key changes arising from the change in accounting rule for leases. There are other changes required to reconcile the balance sheet items for each company. For more details, readers are advised to read the companies' financial statments.

Also note that all the improvements in EBITDA and FCF compared to the previous FY mentioned above are also because companies do not have to restate the financial statements for the previous FY. Effectively, the financial statements for this FY are not comparable to that of the previous FY. Do not be too happy when you see an increase in EBITDA and FCF figures this year!

P.S. I am vested in Hour Glass.

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