Letter number 122 of September 2019

  • NEW

News : What's wrong with new accounting rules regarding operating leases

We’ve already had the opportunity to express the rather dim view we take of the IASB’s plans in terms of reforming ordinary leases (or operating leases), aimed at aligning the way that they are booked with that of financial leases (leasing), during the very long gestation period of IFRS 16, which is finally applicable for financial years that begin after 1 January 2019[1].

This is another unfortunate example of the Shadokian principle of “why make it simple when you can make it complicated?” or the “3% law” whereby the regulatory powers just cannot stop themselves from introducing laws or regulations that apply to all, in order to prevent deviant behaviour on the part of only 3% of agents.

The economic principle

In the period between 1980 and1990, some groups in clearly defined sectors such as the hotel, airline and cinema theatre sectors, began to rent their assets rather than own them or to acquire them under financial leases in order to reduce debt on their balance sheets. This is not the case for the vast majority of companies. For them, the choice is not between renting under an operating lease or renting under a financial lease. They rent under an operating lease when they want to retain operating flexibility, so as to be able to adapt the size of their real estate assets to that of their business as quickly as possible. They rent under a financial lease when they want to remain in the premises long term and they retain the option of acquiring these premises on expiry of the financial lease, often at token price, and which they do not have the resources to acquire today owing to a shortage of cash or their being unable to take out a standard loan. So this is a classic situation of credit which is very different from an operating lease, and which is justification for two different methods for booking two different types of operations, with all due respect to the IASB.

The latter could quite simply have asked companies to set out future lease payments year after year in an appendix to their accounts, which would enable anybody who so wished, to make any adjustments they may wish to make, which is what rating agencies already to for airline companies, hotels, etc. But no, that would have been too easy.

There’s nothing quite like a grand reform that changes EBITDA, EBIT, net debt and operating cash flow and pollutes free cash flows, all at the same time!

The accounting mechanism of IFRS 16

Companies that apply IFRS must from now on record a lease right for assets that they lease to an owner, under an operating or financial lease, as fixed assets on the asset side of their balance sheets, whenever the contract exceeds one year, concerns an asset with a value that exceeds $5,000, the rent is not indexed to a variable indicator such as sales made in the rented premises (store, cinema theatre), and the contract cannot be classified as a service provision, for example renting 1,000 sqm of warehouse space in a hangar, without the location of the space in the hangar being specifically defined and which may vary in actual circumstances.

In order to define the recorded value as a lease right on the balance sheet, the rental payments set for the likely term of the lease agreement need to be discounted. The discount rate is either the implicit interest rate resulting from the lease agreement (financial) or the marginal interest rate at which the company is able to borrow to finance the acquisition of the asset leased under an operating lease. The asset is then amortised on a straight-line basis over the term of the lease agreement. The company records a new financial debt on the liabilities side of the balance sheet for this new asset. This debt is reduced every year by an amount that corresponds to the rent paid less financial expense calculated at the interest rate. During the first years, the rental debt is thus higher than the amount of the leased asset.

 On the income statement, the rental payment no longer appears under other external charges or operating cash costs. Financial expense, resulting from the rental debt on the balance sheet times the interest rate, and depreciation and amortisation of the user right amortised over the term of the lease agreement, are recorded. The sum of these two amounts will usually be different from the rent paid: it will be more than the rent at the beginning of the agreement and less at the end. In appearance, EBITDA is increased by the amount of the rent and EBIT by the amount of financial expenses calculated in this way. We’ll come back to “in appearance” later.

On the cash flow statement, operating cash flow is increased by the depreciation and amortisation of the leased assets.

Readers should now pause for a moment and pinch themselves. No, you’re not dreaming! We’ve got a change in an accounting rule that does not alter a cash flow in reality, but does however modify operating cash flows on IFRS cash flow statements!!!

The final reconciliation with the change in the cash position, given that the IASB is unfortunately unable to magic up hard cash on a company’s books, is made in the cash flows with a fake cash outflow resulting from the reduction in rental debts.

In the US

US accounting standards are also evolving in the matter of booking rentals. In the same way as for IFRS, a lease right is recorded on the balance sheet under fixed assets with a financial rental debt on the other side. But in a much more consensual way, US groups keep rental payments under operating leases on income and cash flow statements as an operating expense and continue to treat financial leases as financial leases. The value of lease rights is reduced on the balance sheet parallel to the rental debt.

In other words, we will no longer be able to make a direct comparison between the EBITDA or EBIT margins of US groups and groups that implement IFRS.

Yet another lost opportunity for reconciling accounting principles. But who ever told you that it was best to keep things simple?

EBITDA that appears to be boosted

What makes EBITDA so popular with financial people? The fact that it’s an advanced indicator of operating cash flows. Assuming that changes in working capital are negligible (which is not an unreasonable assumption after years of efforts to reduce its amount, and in a context of unimpressive growth), and ignoring financial expense (given current very low interest rates) and corporation tax, EBITDA shows more or less how much operating cash flow is available for financing investments or repaying debt.

We recall that by definition, EBITDA corresponds to all operating earnings which sooner or later will be recorded as an inflow of cash, less all operating expenses which sooner or later will be recorded as an outflow of cash.

Anyone who thinks that just because the IASB has decided, in all of its wisdom, to transform a large portion of cash outflows (rents) into depreciation and amortisation that there will be a parallel increase in EBITDA, is being incredibly naive. Does this reform modify the company’s operating cash flows? Of course not! Finance is not only a matter of arithmetic! EBITDA is EBITDA. EBITDA existed before many of the accounting standards did. More than just a calculation, EBITDA is a concept as we saw above.

IFRS 16 and lenders

Lenders, moreover, have not been misled. They make intensive use of the net bank and financial debt / EBITDA ratio in loan agreements, either to define a limit that will trigger early repayment of the loan (financial covenant[2]), or to modulate the level of the interest margin due (margin grid). The most commonly used benchmark ratio is leverage: net debt / EBITDA. This ratio will be deformed de facto by the implementation of IFRS 16 because net debt will be increased by the rent debt, and EBITDA by the amount of rent. The magnitude and even the direction of this deformation will depend largely on the nature and term of the company’s operating leases.

Relatively old loan agreements did not make specific provision for the implementation of this new standard. Some of them contain a general review clause for changes in accounting principles, proposing that stakeholders make every endeavour to amend the agreement in the event of changes in accounting principles so that the effects of the contract are unchanged. Accordingly, we saw adjustments involving the covenant or margin grid when IFRS 10, 11 and 12 were implemented at companies shifting to the equity method for large stakes that were previously consolidated using the proportional method (thus impacting both EBITDA and net debt).

As companies have been anticipating the implementation of IFRS 16 for some time, they have taken this change into account in loan agreements put in place over recent months. Nevertheless, as the impact on numbers has not yet been finalised or is not fully understood by the financial partners, market consensus is to use ratios and covenants for data excluding IFRS 16. Companies that have made this choice (i.e. the vast majority) will thus in the future have to present the impact of IFRS 16 in the accounts so that this can be reversed in order to calculate credit ratios, and this will have to happen, in theory, throughout the term of the loan.

So this is another big success for IFRS as there are some companies that are going to have to present two sets of accounts[3]. Proof that this standard is far from being appreciated by all!

It is however likely that in time, banks and companies will adjust their practices and converge towards ratios and covenants taken directly from the accounts, including IFRS 16. Accounting policies will then have been adjusted in in the minds of bankers and they will not be shocked to see a ratio of 1.3 for Air France as the latter includes leased air craft (when at 0.4x this was not the case but it is true that Air France was already communicating a net adjusted debt / EBITDAR ratio of 2.1x in 2017).

IFRS and business valuation

For business valuation, this modification of accounting policies conceals a major trap in the determining of free cash flows. It could be believed that the apparent increase in EBITDA offsets, in terms of valuation, the increase in financial debt to be taken into account in the bridge from the entreprise value to the value of equity, and that all was well. This would be a serious mistake!

If we consider that the apparent increase in EBITDA is more or less perpetual, at least while the company is operational (which is what will happen as a result of discounting an “IFRS 16-inflated” EBITDA to infinity with this fake depreciation and amortisation), on the other side, the additional debt is limited to the likely term of the lease agreements in place. So, the “IFRS 16-style” debt is massively undervalued by all future rents that will be paid after the end of the existing lease agreements, as these, unless they are renewed, will be replaced by other lease agreements.

To illustrate this point, let’s take the example of Nestlé which published in 2018 financial statements with the application of IFRS 16 from this year. Operating rental payments amount to SFr 994m and they are partially replaced with SFr 705m of “IFRS 16-style” depreciation and amortisation. With a cost of capital of around 6.5%, the additional value of this fictitious depreciation and amortisation which inflates the appearance of EBITDA is SFr 10.8bn, while the new debt on the balance sheet for operating lease commitments is SFr 3.3bn. Which is a difference of SFr 7.5bn and corresponds to 3% of the value of Nestlé’s equity capital. 3% is not a lot, but if it’s a mistake that can be avoided, why not avoid it? But this figure of 3% is low because Nestlé does not have a lot of operating leases in place.

Just imagine what it would be for a company that is not quite as wealthy as the Swiss giant. For EDF for example, the French energy giant, which puts its supplementary “IFRS 16-style” EBITDA at €0.5bn, for new debt of €4.5bn, the impact on the value of equity of a speedy and erroneous calculation is €4bn, or 11% of its market capitalisation. We arrive at a figure of 13% for the largest 120 French listed companies (with an estimation of €116bn in rental debt, €28bn in rental payments and a cost of capital of 7.5%), if instead of taking a growth rate to perpetuity of 0%, as in previous examples, we take 1.5%.

So what’s to be done?

Our recommendation is to unravel IFRS 16 when analysing financial statements, by cancelling the lease right and the rental debt on the balance sheet, and setting off any balance of these two amounts against equity capital (which has been drained with the implementation of IFRS 16); to correct financial expense and depreciation and amortisation which have been inflated by IFRS 16 in order to get back to depreciation and amortisation that covers non-cash expenditure, as it should do, and not these vague and arbitrary amounts. It is true that an initial break with this principle was introduced for financial leases, but everybody knows that a financial lease is a financial debt, and that reflecting an economic reality beyond a legal appearance makes sense. This is a point on which consensus was reached very quickly and which nobody disputes. This is far from the case for operating leases where the IASB did not seek consensus, failed to demonstrate that IFRS 16 was better than the standard it was replacing, and used strong-arm tactics to push it through.

As long as companies publish the breakdown of their real and fake depreciation and amortisation, their real and fake financial expenses, their rental debts under financial leases and operating leases, analysts will be able to do their jobs properly. And we do not see how companies will be able to stop computing this information, even if only to carry out their fixed assets impairment tests required under IFRS, unless valuers start to discount something other than cash flows!

We can only hope that one day, the IASB will realise that it is possible to make things simple rather than to complicate them. In this regard, the US approach seems to us to be both pragmatic and consensual. Rather a pity for the Europeans, but that’s just the way it is.



Statistics : The valuation of small listed companies

Since several months, Infront Analytics, which provides the financial databases for the vernimmen.com website[1], has been publishing an index for the valuation of small listed stocks in the euro zone.

It is made up of more than 1,100 companies in the euro zone, 67% of which are worth between €15 million and €150 million, the remainder between €150 million and €500 million. The median valuation is €82m, so we are really in the small cap world, and the median EBITDA margin is 10.8%.

France provides 28% of the sample, when Germany is added, it reaches 50%. The addition of Italy, Spain and Benelux makes it more than three-quarters.

The industrial products, technology and health sectors make up half of the sample.

The Eurozone Small Cap Infront valuation index rebounded strongly in the first quarter of 2019 with a median level of Entreprise value to EBITDA (EV/EBITDA) of 8.6x, compared to 8.0x at the end of 2018, an increase explained by a better context on the equity markets, which also benefited the small caps segment.


[1] You can consult it by clicking here

Research : An empirical assessment of agency conflicts

With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise

In economics, agency problems involve situations in which an economic player (the agent) acts on behalf of another (the principal) although their interests may diverge. Such situations occur frequently in corporate finance and they result in both loss of value and transfers of value between stakeholders[1]. Measuring the extent of these agency conflicts is a particularly arduous task. The article we look at this month[2] takes up this challenge.

Morellec et al use a financing model derived from the theory of trade-off. Although this approach is sometimes called into question[3], the model used has the advantage of being sufficiently flexible to integrate a number of key parameters in terms of agency. The two essential parameters that the study seeks to measure in particular are:

1- The share of free cash flows (FCFs) that can be captured by the majority shareholder over and above its share in the company’s capital, which is sometimes referred to as private profits. These are at the heart of the conflict between majority and minority shareholders. In particular, as the majority shareholder can only capture these amounts on FCFs after financial expense, a high level of private profits results in disagreement on the level of debt. The majority shareholder will choose financial leverage that is lower than the optimal level, in order to capture more private profits.

2- Shareholders’ negotiating power in the event of default. If shareholders have a large amount of negotiating power, they will be able to recover a larger share of residual wealth in the event of default on debt repayment. Accordingly, this will encourage them to declare default more quickly and upstream, rational creditors will require a higher interest rate. Given that debt is more expensive, the target financial leverage will be lower.

Finally, in order to estimate the costs of agency, Morrelec et al observe the level, the breakdown and the dynamics of the financial leverage and, with the help of the model, arrive at an estimation of agency parameters. To do so, they studied a sample of over 12,000 companies in 14 countries (the USA, Japan and the 12 main European markets). They take the legal and tax environment of each country into account.

Out of the whole sample, the share of FCFs captures as private profits is estimated at 2.6% (median value) or 4.4% (average). Shareholders’ negotiating power in the event of default is estimated at around half (45%) of remaining wealth. Over and above these estimations, the key take-aways from the study are as follows:

Differences between countries are small. In particular, the often-vaunted superiority of British common law over civil law (France, Germany or Scandinavia) for combating agency conflicts can only be observed in extreme cases.

The main determinants of agency conflicts are specific to each company. These conflicts are higher at companies where the shareholder base is concentrated and which have large amounts of cash, as well as at companies experiencing growth and those holding intangible assets. These criteria are the same in all of the countries looked at in this article.

Even though these different effects are already known, what makes this article interesting is that it provides a credible quantification of the severity of agency conflicts. It also shows that the determinants of these conflicts are the same everywhere and do not depend much on the country where the company is located (or at least when looking at developed markets). Finally, the article also shows that reforms begun in Europe to increase the power of minority shareholders (in France and Italy in particular), have led to a decrease in the estimated level of agency conflicts. These results are reassuring both as regards the efficiency of these reforms as well as the article’s ability to measure agency conflicts accurately!


[1] For more on agency conflict, see chapter 26 of the Vernimmen.

[2] E. Morellec, B. Nikolov and N. Schurhoff (2018), “Agency conflicts around the world”, Review of Financial Studies, vol. 31, page 4232 to 4287.


Q&A : Two questions regarding shareholder loans

What interest rate should a parent company apply for a medium-term shareholder loan to its subsidiary?

A shareholder loan is granted at a similar interest rate to that which a bank would offer during the same period and over the same term, plus a margin. This extra margin remunerates the fact that unlike a standard lender which, if the subsidiary runs into trouble, would not hesitate to force it into liquidation so that it could recover what is due to it, a parent company would not behave in this way with its subsidiary. To a certain extent, a shareholder loan is de facto subordinated to repayment of loans granted by other lenders which often require this to be recorded in some form or another.


Should the shareholder require a different return on equity from the subsidiary based on whether it is  financed with a shareholder loan or a standard loan?

The shareholder should require a higher rate of return on equity from the subsidiary when it is financed by a bank loan than when it is financed by a shareholder loan (itself), since the parent company isn’t crazy and won’t cause its subsidiary to fail, whereas a lending bank could well do so.

This is perfectly logical as in the case of financing using a shareholder loan, the subsidiary’s equity costs less than in the case of bank financing, with shareholder debt costing less than a bank loan. However, with bank financing, the subsidiary’s equity costs more than in the case of a shareholder loan, with bank debt that costs more than a shareholder loan. So, the average weighted cost of these sources (equity and shareholder or bank loan) is identical, and it’s the company’s cost of capital that doesn’t depend on the way in which the company is financed.


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.


Public accounting is different from private accounting!

At the beginning of August, the United Kingdom announced a contraction of its GDP by 0.2% in the second quarter of the year, after an expansion of 0.5% in the first quarter of 2019, by blaming Brexit for these developments: British companies produced a lot in the first quarter to build up precautionary stocks in anticipation of an EU exit on 29 March; and as this was postponed by a few months, in the second quarter British companies produced much less to reduce precautionary stocks, hence the contraction in the second quarter.

In private accounting, where very little is reported on production but almost exclusively on sales and results, the second quarter would have been a good second quarter with sales and results in contrast with the first quarter, because producing for storage does not generate results or record sales.

But public accounting is more interested in the activity (to do) and private accounting in sales. In between are stocks that are normally only time lags, as the recent example of the United Kingdom reminds us. In the third quarter, a good GDP figure is expected, with UK companies restocking precautionary stocks in preparation for 31 October, before a fourth quarter that is expected to be worse due to destocking. But it is true that we are in the land of stop and go.


Beware of EBITDAs currently published

Like the one of Club Med, which posted an 88% increase in the first half of 2019 (to €180m), but of which 85% (out of 88%) was due to the entry into force of the new IFRS 16 standard on operating leases[2].
Pay attention not only to the evolution of EBITDA, but also to its meaning, which is strongly affected by this new standard, of which we have had the opportunity to express all the evil of which we think (Why make it simple when you can make it complicated?).
What made EBITDA popular is the fact that it is a leading indicator of its operating cash flow that the company will receive due to its activity. Indeed, it is the difference between all operating income and expenses that will sooner or later result in a cash inflow or outflow. 
This is no longer the case after IFRS 16, since part of the EBITDA (€82 million in the case of Club Med, out of €180 million) corresponds to a fraction of the operating rents already paid by Club Med to the owners of the properties it leases, and therefore not available for investments or to repay debts. For the time being, companies publish, like Club Med, the EBITDA for the first half of the year before and after IFRS 16 in order to ensure comparability of the financial statements. Let us hope that this will continue to be the case in the future so that readers of the accounts can find their way around.
And to think that the IASB has sold its reform by saying that it would improve financial reporting... 
Optimists will think that the IASB will eventually do as Technip and FMC or Altria and Philip Morris who have just announced undoing what they did a few years ago.


[1]  Like it here

[2] See the News article of this letter.