- New accounting rules now place lease liabilities/assets onto the balance sheet of companies.
- Rule changes are a net improvement for investors in providing clarity in that it reflects true commitments and liabilities paid by the company, which were not recorded on the balance sheet under prior accounting standards.
- Caution, there will be a decline in profitability and asset ratios; while the new rules changes benefit transparency of commitments by the company, investors with current holdings in companies which rent/lease real estate, vehicles, machines will be most affected since the commitments are now reflected in liabilities and asset.
- We will walk you through how this affects the company profitability and return on asset metrics with an example, then take a look at two real-life case studies using Japan Foods and Challenger.
There was a major change in the accounting principles at the start of this year and would affect many companies who lease a lot of stuff such as real estate, vehicles and machines.
Given that Singapore is known for expensive rents, it is going to be a significant impact.
Let’s use an example to illustrate this simply.
You are a chicken rice entrepreneur. You want to start a stall to dish out your fabulous chicken rice in Singapore.
Going around a few kopitiams you narrowed down to one to set up shop. The landlord demands $10,000 rent per month and you would need to commit and sign a tenancy agreement for the next 3 years.
You have to pay rent regardless if you continue to operate the business. Else find somebody else to take over the stall. Tough luck.
This means that you need to commit to:
$10,000 x 12 months x 3 years = $360,000 of rent.
You might see this as a hefty cost to promise and that would affect your finances.
But in the old accounting principle, this is known as operating lease and it is not recorded as a liability on your balance sheet – even though you are contracted to pay rent.
Under the new rules, you would have to record this as a liability as well as an asset.
- The liability part of the ruling is simple to understand because you promised to owe the landlord the payment going into the future.
- The asset part of the ruling is harder to understand since you don’t own the stall. But you can also flip it around and say that the landlord has also given you exclusivity to use the stall for the next 3 years, so the right to use can be considered an asset.
You might be thinking that there would be no significant changes since similar figures are added to both the assets and liabilities in this exercise.
I would agree that the Net Asset Value (NAV) wouldn’t change much but financial ratios that only take either the asset or liability value will see big changes.
Since the new rulings increase total assets reflected on the balance sheet of companies, Gross Profitability, which is gross profits/total assets will naturally shrink.
This ruling will impact restaurants as well as those companies with retail shops. These shops are usually located in malls owned by REITs and we know that the rents aren’t cheap and are increasing over time as well.
Let’s look at some examples.
Example #1 – Japan Foods (SGX:5OI)
Japan Foods (SGX:5OI) operates the Ajisen and Menya Musashi ramen restaurants among other brands.
You would be able to find their shops in most malls. Below is the first-quarter results in 2019.
Here are the changes:
- You can see that the ‘Right-of-use assets’ worth $26m has been added to the assets which did not appear in 2018.
- ‘Lease liabilities’ of $13.3m and $12.9m were added to the current and non-current liabilities respectively.
- The total assets increased from $43m to $71m
- The total liabilities ballooned from $10m to $37m
You can see the whole balance sheet got expanded. Gross Profitability has also declined.
- The Gross Profitability in 2018 was about ($14m gross profits x 4 quarters) / $43m total assets = 130%
- The Gross Profitability in 2019 would be about ($15m gross profits x 4 quarters) / $72m total assets = 83%
- For Japan Foods, the ROA would have declined from 11% to 6%.
Example #2 – Challenger (SGX:573)
Challenger is another company with multiple outlets across the country in major malls. They too would be impacted by the capitalisation of operating leases too.
Here’s their 2H2019 balance sheet.
Here are the changes:
- You can see that the ‘Right-of-use assets’ worth $17m has been added to the assets which did not appear in 2018.
- ‘Lease liabilities’ of $11m and $6m were added to the non-current and current liabilities respectively.
- The total assets increased from $131m to $150m
- The total liabilities ballooned from $39m to $56m
Let’s look at the impact to the Gross Profitability.
- The Gross Profitability in 2018 was about ($33m gross profits x 2 half years) / $131m total assets = 50%
- The Gross Profitability in 2019 would be about ($34m gross profits x 2 half years) / $150m total assets = 45%
- As for ROA, it would have declined from 14% to 11%.
The result is also a dip in Gross Profitability.
The new accounting rules will impact companies with high operating leases such as restaurants, retail shops, and transportation (if they lease a lot of vehicles).
Previously these leases are considered off-balance sheet items but now they are included in the main balance sheet, inflating both assets and liabilities.
This ruling change will impact some of the financial ratios you have used to evaluate the stocks.
Once their annual reports are released, some of these companies which previously might have been regarded as more profitable than they truly were might see some amount of correction. And it is important all of you as investors are aware of this.
Thus it is important to re-evaluate them based on the new rules. Take a look at your stocks if you haven’t!