IFRS 16 – large change in lease accounting

I talk much more about finance than accounting on this website, although I am a professional accountant. A good analogy is math and physics – people in both fields tend to understand the other, more so than the difference between chemistry and biology.

Effective this year, companies will have to adopt IFRS 16, which governs accounting for leases.

Other than enriching accounting consultants that will have to dig into the structures of leases of various firms, this will have a material impact of the reported assets and liabilities on a company’s balance sheet. New students of accounting will also have one more layer of complexity to memorize at exam time, while textbook manufacturers will undoubtedly be happy.

Specifically, the distinction between an operating lease vs. a capital/finance lease is removed and instead all leases will have an asset and liability component. The asset of the lease (the item which you are buying the rights to use) will be depreciated over time, coupled with an interest expense component for the financing cost of the lease, with a depreciation charge to reduce the asset value.

From an investment perspective this changes the character of “EBITDA”, where companies that heavily use operating leases would previously have expensed such costs (typically in operating expenses), while after IFRS 16 is implemented, they will suddenly find their EBITDAs increase because the lease cost will have strictly an interest and depreciation component. They are still expenses, but the characterization of the expense is now changed. This will be an accounting windfall for companies that traditionally are valued on EBITDA metrics.

So if you find it annoying how companies use EBITDA as a proxy of profitability (which it could be given the right assumptions – but most companies abuse the EBITDA number to inflate the perception of their profitability), after IFRS 16, good luck! Just remember, you can only live on after-tax cash flows and not EBITDA!

The other strange implication of the rule is that once a lease is initiated, it will initially be more expensive at the beginning of the lease, and less expensive later in the lease as the embedded interest expense of the lease declines. So let’s say you lease a million dollar jet for 10 years, your expense profile, depending on your cost of capital component, on year 1 would be $125,000 while on year 10 would be $75,000 even if you fork out $100,000/year to use it. Investors have to add one more layer of effort to separate what is happening on the income statement with what is happening on the cash side of things. (Even this example is not quite correct – the lease asset may be $1 million, but the liability is going to be bigger since nobody will want to lease a $1 million jet for a $1 million stream of cash).

You have to love these accounting standards that make life even more complicated for the layman in the name of increasing accuracy. Currently, an investor could look at the notes on the financial statements to understand what a company’s future lease commitments were. One-shoe-fits-all accounting sounds great in principle but it has the consequence of making financial statements more difficult to read and understand between companies even though the goal is to make them directly comparable.

Markets chasing yield again

Life looks rosy again in the financial markets!

So going from the “the world is about to end” mantra in December, we’re back once again to sunny skies.

In particular, interest rate futures are projecting a rate cut later this year, which is a complete turnaround to events just three months ago.

So as a result, almost anything with a yield has been bidded up since the beginning of the calendar year.

It’s as if everything that has been thrown away in the previous rising rate environment is now back in vogue again. It’s like the proverbial crowd rushing out of the exits in December, only to rush back in January?

Very fascinating.

S&P/TSX 2019 year-end projections and predictions

Article on the Financial Post of various analysts predicting where the TSX will end up in 2019. Right now it closed at 14,222. I’ve put percentages next to the predictions:

Predictions for TSX at the end of 2019:
Laurentian Bank of Canada — 18,500 points (+30.0%)
BMO Capital Markets — 18,000 points (+26.6%)
National Bank of Canada — 16,600 points (+16.7%)
Russell Investments — 16,000 points (+11.1%)
CIBC — 15,600 points (+9.7%)
Sunlife Global Investments — 15,000 points (+5.5%)

I wish this list was more comprehensive. Sadly after doing a couple minutes of scouring the internet, I could not find a decent list of December 2018 predictions made in December 2017 other than Russell Investments predicted in late 2017 that the TSX would close 2018 at 16,900. I’m sure my readers can find a more appropriate list.

All I can say is the following – the numbers above also are based on a price index. The total return of the TSX includes dividends, and this would increase the stated percentages by approximately 3%. So the worst prediction of the six above would show a total return on the TSX of roughly 8.5%.

The TSX’s total return (dividends reinvested), as measured over the past decade, is approximately a shade over +5% compounded annually. Recall that 10 years ago was in the depths of the financial crisis and was one of the best investing opportunities in a generation.

If I was a broad market investor, I’d be concerned at this degree of bullishness.

No interest rate changes in 2019?

Take a look at the current snapshot of short-term interest rate futures (for those that do not know how they trade, ZQ is the 30-day Fed Funds rate futures and BAX are the Canadian 3-month banker acceptance rate futures, our closest proxy – the price is 100 minus the implied rate in percentage, so a price of 97.6 would equate to a 2.4% rate):

This creates some interesting financial bets, such as:

1. Do you believe the Fed will continue raising rates?
2. Do you believe the Bank of Canada will raise rates? If so, you can easily bet on this outcome. The next two policy announcements are on January 9, 2019 and March 6, 2019, and the BAX futures imply a very small chance of a rate decrease, but for the most part expect rates to remain the same (i.e. if you bet on the rates not changing you would stand to profit a tiny bit). The current rates as of today are 2.24% (97.76).

Given what has happened in the markets in the past three months, market participants are clearly pricing in that the central banks are going to stop raising rates. In particular, a quarter-point rise in the Bank of Canada rate will completely flatten the yield curve – currently 3-month treasury bill rates are 1.67%, but a quarter point rise will surely take them up to the 2 to 10-year level which are all currently trading around 190-200bps.

These are very strange times indeed.

The question then becomes a bit strange when one puts yourself in the shoes of the Federal Reserve or the Bank of Canada – do you want to raise rates to the point where you will invert the yield curve? It’s a bit gutsy to do so.

The Bank of Canada, as late as their December 5, 2018 policy announcement included the following sentence:

Weighing all of these developments, Governing Council continues to judge that the policy interest rate will need to rise into a neutral range to achieve the inflation target.

Does the Bank of Canada will believe that rates still need to climb to this neutral range?

For reference, the “neutral range” is defined as such:

The neutral nominal policy rate is defined as the real rate consistent with output sustainably at its potential level and inflation equal to target, on an ongoing basis, plus 2 per cent for the inflation target It is a medium- to long-term equilibrium concept For Canada, the neutral rate is estimated to be between 2.5 and 3.5 per cent. The economic projection is based on the midpoint of this range, the same rate as in the July Report.

The January 9, 2019 meeting is thus to be more interesting than most, considering what has transpired since the last meeting – including the Canada-China trade implications on the detainment of the Huawei CFO.

One of the likely implications of the realization of the cessation of rate increases is that there will once again be a chase for fixed income yield. It would probably open the door for more leveraged spread trading (e.g. borrow CAD at 2%, invest at 6% type trading, with the knowledge that the 2% borrow rate will not get more expensive).

The other observation is that the central banks might pause, but if markets start to normalize once again, may continue the tightening bias. Indeed, the Federal Reserve is still implicitly tightening with the reversal of QE and keeping this chart in mind (FRED Data) makes one realize there is a long way to go before things normalize on the Federal Reserve’s balance sheet.