Why is the accounting treatment changing?

The International Accounting Standards Board (IASB) has decided that, for financial years beginning from January 2019, operating leases will essentially cease to exist. The value of rented assets will have to be shown as an asset on a company's balance sheet and the obligation to pay rents in the future will be shown as a financial liability similar to borrowings.

The IASB believes that investors and analysts do not have a complete picture of a company's financial position with the current treatment of operating leases. It believes that a company's financial liabilities are understated when it has significant future rent obligations.

It is also makes it difficult to compare similar companies where one rents assets and the other owns assets without making significant adjustments.

Generally speaking, I think this is a very good idea. It is too easy - particularly for inexperienced investors - to think that a company is debt free when it isn't. Retailers are a prime example of this. The inability to pay rents on high street shops is a major reason for retailers going bankrupt even if they have no borrowings.

More importantly, renting assets understates the real value of assets employed in a business and overstates the true ROCE it is making. Think about this for a moment: is it really true that two identical retail businesses with identical assets, profits and cash flows can have different returns on capital just because one chooses to rent rather than own its shops?

This is why high street retailers with rented shops appear to have no debts and high ROCE. Some do, but many do not when the adjustments proposed by the new accounting standard are applied.

Credit rating agencies and many professional analysts have been making these adjustments for some time. From 2019, no-one will have to and I think that is a good thing.

The effect on income statements

This is best explained with an example. From 2019, the operating lease expense line will completely disappear from company income statements. Instead, the expense will be reallocated between depreciation and interest expenses.

From 2019, the operating lease expense line will completely disappear from company income statements. Instead, the expense will be reallocated between depreciation and interest expenses.

Let's take a look at the impact on a company with £100m of operating lease expenses:

• EBITDA will increase by £100m. The whole operating lease expense consists of interest and depreciation so is added back to the unadjusted EBITDA. EBITDA is telling us what profits are before these two expenses are deducted.
• Depreciation will increase by £70m. The depreciation part of the operating lease expense is added to the existing depreciation on other fixed assets.
• EBIT increases by £30m. This is because the interest part of the operating lease expense has been reallocated to the interest line.
• Interest expense increases by £30m.
• Profit before tax is unchanged.
• The effect on profits after tax and earnings per share (EPS) is uncertain. This is because it depends on how the tax authorities treat the tax deductibility of lease interest. Personally, I do not expect a big change.

Effect on financial ratios

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