New Lease Accounting Rule Impact On Companies and Investors- Making Something Out of Nothing

The new accounting standard FRS116 on leases came into effect on 1^st Jan 2019. The “right of use” asset model basically attempt to plug the loophole of off-balance sheet liabilities. Basically, for operating lease assets, companies are now required to capitalize the present value of future lease payments of such arrangement as a direct fixed asset and also to recognize a theoretical liability. This gives rise to a strange phenomenon whereby an arbitrary financing cost is also created monthly for the right of use of the asset during the unwinding of the interest component in the lease liability. From the cash flow statement perspective, companies now have to account for the monthly lease payments into (i) repayment of principal portion and (ii) the cost of financing the “right of use” asset. From a retail investor perspective, it does lead to massive confusion over the understanding of the traditional Statement of Comprehensive Income (Profit and Loss statement) as well as cashflow statement.

Majority or only a minority of companies affected?

Majority of companies are being impacted by this change in accounting. For example, most business would definitely have an office lease or industrial premises lease. Since the lease of premises is one of the huge cost components of business, this impact can be very significant on the financials.

To illustrate this, a company may have signed for a 5 year industrial lease for S$120K per month. Total contractual obligation thus amounted to S$7.20Mil over 5 years. Under the new accounting rule, the present value (assuming the benchmark incremental borrowing rate is 3.5% and the landlord requires prepayment on 1^st day of month) of future lease payment will be S$6.62Mil. The differences of S$584K is deemed as the financing cost over the 5 year period.

Key parameters to work out the present value of lease payments

What are the differences between the new profit and loss impact relative to previous method on lease accounting?

Instead of recognizing rental expense in a straight line over 60mths under the old method, the new accounting rules does not have any rental expense for operating lease with the exception of low value or items less than 1 year. The new accounting rules recognizes (i) depreciation and the theoretical (ii) finance cost of liabilities unwinding into the profit and loss consideration.

The mind blogging aspect is that the new rule loads up expenses upfront at the onset of the first few periods of the lease period whereas the previous method has a simpler approach of constant and equal lease expense every month. This is illustrated in the screenshot from period 1 to period 60. The fluctuating figures make it hard to do an accurate forecast of the future business performance with the declining profit and loss impact especially towards the end of the lease whereby the liabilities have been significantly lowered hence very little finance cost at this juncture.

 

Screenshot of monthly profit and loss impact of new recognition method vs previous method

The experts who implemented this new rule rationalize the fluctuation by justifying that this is the realistic application of the time value of money concept.

Further confusing aspects of new accounting rule

1.   As mentioned above, the new accounting rule stipulates the recognition of operating lease has exceptions for low carrying value lease contracts or contracts for less than 1 year. What this meant is that the rules still allow one to use back the old method for such “immaterial” lease contracts to cater to complaints from commercial practitioners on the practicality of implementation for every operating lease in their business which will be too onerous.

2.   If the operating lease contract comes with an option to renew upon the end of the contracted lease (which is actually very common), the new rule requires one to use a judgmental estimation of the probability to decide whether the contract period should take this additional option into consideration to derive the total value of future payments for lease liabilities. Once you leave things to judgment, hell breaks loose eventually and leads to big fluctuation in future financial results.

Summary

I do not like the new accounting rule as it makes an assessment of current potential businesses identified for investment more complex due to the monthly fluctuation and the additional mental acrobatics during analysis. It also makes the overall profit and loss weird with front-loading of expenses and then a favorable impact towards the mid to end point of the lease. But it does have added transparency to potential investment company statement of financial position by bringing in contractual lease obligations into the gearing ratio.