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But let\u2019s start at the very beginning. The new standard on lease accounting (IFRS 16) that substitutes the old IAS 17 basically brings almost all lease commitments of the lessee as a liability and a respective \u201cright of use\u201d asset onto the balance sheet starting in the financial year 2019 (for more details on IFRS 16, see <\/strong>https:\/\/www.iasplus.com\/de\/standards\/ifrs\/ifrs-16<\/strong><\/a>, for a working example on how this standard impacts our DCF valuation models from a technical point of view, see <\/strong>https:\/\/valuesque.com\/deutsche-post-more-debt-same-equity-value-the-ifrs-16-financial-analysis-problem-part-1\/<\/strong><\/a>). Two core questions are here obviously: How to determine the amount of the liability (or the asset) for IFRS financial reporting reasons? And does this make sense from an economic point of view?<\/p>\n\n\n\n A very\nsimple example should help to understand this. Imagine a company leases a\nmachine which has a market value of 100 Euros. The company agrees to make lease\npayments of 35,35 Euros in each of the next three years. The (incremental) cost\nof debt of the company is 3%. It is assumed that we live in a financial\nreporting world where the value of liabilities is determined reasonably.<\/p>\n\n\n\n We can now determine the financial cost of this leasing contract by determining the internal rate of return of the project (the so called \u201crate implicit in the lease\u201d RIL<\/em>):<\/p>\n\n\n\n Here RIL<\/em> exactly equals the cost of debt.\nObviously in this case it does not matter from a valuation point of view whether\nthe company a) enters into the lease contract or b) buys the asset directly and\nfinances this purchase by taking a 3 year annuity loan from the bank at its\nrespective cost of debt.<\/p>\n\n\n\n But now imagine, the company agrees to make annual lease payments of 36,72 Euros instead (all other things being equal). Determining the RIL<\/em> leads to:<\/p>\n\n\n\n The RIL<\/em> is now obviously higher than the\ncost of debt of 3%. Purchasing the machine and simultaneously debt-financing it\nwould be the cheaper solution. Hence, one might wonder why the company should\nenter into such a leasing contract. Three possible reasons:<\/p>\n\n\n\n Without saying\ntoo much here: In reality we most often see reason 3. But whatever it is in a\nparticular real world case, it is worth to analyse the economic impact of all\nthree cases below.<\/p>\n\n\n\n One thing is the same for all three reasons: The company makes the same payment commitments and the present value of these payment commitments is calculated by discounting them at the opportunity cost of capital<\/em>. This liability side view is not at all different from the valuation of a bond or of a loan. It does not matter to whom a company owes money: nobody would value a high-coupon bond by discounting it at the coupon rate but always at the opportunity cost of debt capital<\/em>). And the respective opportunity cost of debt capital is here the cost of debt of the company (3%). Hence the value of the liability is:<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n 2. This case must immediately raise the question on how we should know the market value of the machine here when it cannot be bought directly. Obviously, there is no real market value. The company bought something via leasing at a price a normal market participant has to pay for it. This means there are not necessarily any adjustments necessary from a financial statement point of view.<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n Comment: It might be that the company has to write down the asset for other reasons (e.g. lower value-in-use). This would bring us back to reason 1. But in this case the question should be asked why the company goes for such a transaction anyway if it does not make economic sense.<\/p>\n\n\n\n 3. Here the company paid a fair price for a package of a) the right of using the machine and b) the benefit of some additional options or guarantees. The balance sheet should look as follows.<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n This is how\nbalance sheets should look like in a sound accounting environment. However,\nthis economic view is not necessarily the view of IFRS standard setters (it\nbasically hasn\u2019t been the view already before the introduction of IFRS 16, but\nnow it becomes all much more apparent). Without going to deep into the details,\nIFRS 16 offers three different ways of determining leasing liabilities now at\ntime of transition:<\/p>\n\n\n\n The interesting variant is obviously the full retrospective approach (FRA). Here companies can \u2013 under certain circumstances \u2013 use a different discount rate for determining the lease liability (i.e. the RIL<\/em>) than the one which makes sense from an economic point of view (i.e. the cost of debt or incremental borrowing rate). Using the RIL<\/em> for discounting and taking our example above, leads to a present value of the lease liability of 100 Euros:<\/p>\n\n\n\n This is not a big surprise as by definition the liability (i.e. the result of the present value calculation) has to equal the asset value (100 Euros) if the discount rate equals the RIL<\/em>. The balance sheet in this FRA\/RIL<\/em> case would look as follows:<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n In this\ncase it is highly improbable that the lease liability will be upward adjusted\nto the economic value over time. If IFRS 16 allows for this, then it will also\nbe kept. <\/p>\n\n\n\n When\nlooking at the balance sheet of an FRA\/RIL<\/em>\nreporting company one immediately gets the point. The liability is understated if\ncompanies use the RIL<\/em> for discounting\n(no matter which of the three reasons above is the actual one). It does not\nmirror the economic liability! Companies now look more attractive from a credit\npoint of view than they actually are!<\/p>\n\n\n\n And\ncompanies are aware of this positive resemblance. E.g., the French retailer Casino\nGuichard-Perrachon S.A. which follow the FRA can now apply discount rates only slightly\nshort of being double-digit because their Brazilian leasing activities have\nvaluable cancellation options. The operating lease liabilities on its balance\nsheet are, as a consequence, much smaller than they should be from an economic\npoint of view. And Groupe Casino is not alone.<\/p>\n\n\n\n However,\nnot every FRA company manages to go this way. In fact, using the RIL<\/em> as a discount rate is not always straightforward\nin practice. Some feedback that I get currently shows that for companies having\nopted for the FRA it is sometimes easier, sometimes not so easy to go for the RIL<\/em> as a discount rate when they opt for\nFRA. Auditors require clear documentation on asset values if the RIL<\/em> should be used as a discount rate.\nThis is particularly problematic for companies that lease real estate (e.g.\nretailers) because of the non-standardization of these assets. It is less\nproblematic for companies rather leasing more standardized assets (e.g.\nairlines leasing airplanes).<\/p>\n\n\n\n But not\nonly the FRA\/RIL<\/em>-companies are\nproblematic. For these companies we at least know that we have to adjust their\nliabilities for analytical reasons (even if imperfect information makes this\nquite difficult in practice). Even more problematic are companies that do not\nfollow FRA but still own-construct their discount rates \u2013 because then it is\nnot so obvious that we have to adjust their liabilities. And this brings us back\nto the original thematic anchor of this article: Royal Dutch Shell Plc.<\/p>\n\n\n\n Shell presented the impact of the IFRS 16 transition in a conference call to investors dated 28 March 2019. Shell made clear that it follows the MRA, and not the FRA, meaning that it has to use the incremental borrowing rate for determining the lease liabilities. So far so good. In the call it presented the following table.<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n As we can\nsee from the table, on average the discount rate used by Shell for discounting\nleasing liabilities is 7.2%. This contrasts to the yields-to-maturity of\noutstanding long-term USD bonds of the company of 3%-4% (and for Eurobonds even\nlower). Quite a difference at first glance!<\/p>\n\n\n\n Of course,\nthis comparison is not very fair. Shell enters into lease contracts via\nsubsidiaries which might be financially ring-fenced and hence have a lower own credit\nquality than the mother company. But still, discount rates at these levels look\nvery expensive. And the discussions and explanations in Shell\u2019s \u201cIFRS 16 update\ncall\u201d do not really help in softening investors\u2019 concerns, neither (important:\nI have not been in the call myself; all the information are taken from the\n\u201cedited transcript\u201d of the call, provided by Thomson Reuters Streetevents).<\/p>\n\n\n\n In the call, Shell\u2019s Executive Vice President Controller Martin ten Brink explained amongst other things the rationale behind the discount rate assumptions. He first explained, that the discount rates are a function of three considerations: the tenure of the lease contract, the nature of the assets (ultra-deep water rigs, LNG vessels and others) and the credit rating of the respective Shell entity. This already raised some questions: Why should one (at least partly) double-count asset risk and credit risk? On the one hand, asset risk is a determinant of credit risk (see the comments on the Merton (1974) model in determining credit risk: https:\/\/valuesque.com\/actuarial-accounting-repair-the-pension-valuation-conundrum\/<\/strong><\/a>). On the other hand \u2013 if you want to take it into account by determining the incremental borrowing rate \u2013 many of the leased assets of Shell should back the loan by their own cash flows which make the financing of them being largely independent of the entity\u2019s credit rating.<\/p>\n\n\n\n Further, Martin\nten Brink commented that \u201c\u2026the 7.2% is the weighted average incremental\nborrowing rate on transition. This is not an indication of the borrowing rate\nto be expected on future lease contracts.\u201d and \u201c\u2026the incremental borrowing rate\nthat we apply on transition is a constructed rate.\u201d This again could not really\nclear the fog around these high discount rates. Is it now a market based borrowing\nrate or not? And if yes: why should a future borrowing rate be different then?\nMartin ten Brink also comments that Shell would not reopen existing leasing\ncontracts with contract partners again in order to lower the interest rate.\nWhile such proceeding is perfectly understandable from a doing-business point\nof view, it unfortunately brings his whole discount rate explanation here\nhighly closely to the RIL<\/em> perspective\n(which is absolutely not what is relevant or appropriate for Shell\u2019s MRA\nreporting approach \u2013 it is about the\nincremental borrowing rate and NOT about the contract terms!).<\/p>\n\n\n\n Certainly, all\nthis could simply be a communication problem. But even after looking deeper\ninto the annual report, I could not find any indication of such high\nincremental borrowing rates for the typical Shell lease project. Again of\ncourse, it could be that some rates implicit in the lease (RIL<\/em>)are set at these high levels but this is not what it is about\nhere (over and over again: Shell follows the MRA! It is about the incremental\nborrowing rate).<\/p>\n\n\n\n Hence, I recalculated the lease liabilities by applying some own analytically derived financing estimates (e.g. Belgian Liquefied Gas transportation specialist Exmar NV can finance LPG vessels at rates of about LIBOR plus 1%-3%, etc.). As I do not know all the details of the Shell leasing portfolio (although a lot of information had been given in the update call), I still had to make a lot of assumptions here, e.g. on different leasing durations. However, even my most conservative scenario shows some clear differences of >10% in the valuation of the lease liabilities of Shell (see graph below).<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n As always, what\nI write is not an investment recommendation and the calculations are made based\non imperfect information. It is also a purely subjective view on Shell\u2019s lease\naccounting. I also cannot disclose all my data sources here which I know\nweakens my message a lot. However, the calculations in the graph really show my\nmost conservative scenario!<\/p>\n\n\n\n So what? Even\nif you have different data sources and see different results, my analytical view\nand also the above comments on the companies following the FRA emphasize how\nimportant it is to look deeper into companies\u2019 IFRS 16 accounting practices\nregarding discount rates. Don\u2019t take it as a given. This even more so true as\nthis standard is new and historical comparability is not possible.<\/p>\n\n\n\n In summary,\nthe main takeaways from first experiences with IFRS 16 lease accounting with\nregards to discount rates are:<\/p>\n\n\n\n In the famous 1959 Billy Wilder movie \u201cSome like it hot\u201d the former Saxophone player and notorious impostor and gambler […]<\/p>\n","protected":false},"author":4,"featured_media":54399,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[75],"tags":[],"class_list":["post-54387","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-english-contributions"],"yoast_head":"\n![\"\"](\"https:\/\/valuesque.com\/wp-content\/uploads\/sites\/3\/2019\/05\/formulaShell1.png\")
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Source: Presentation \u201cIFRS 16 update call\u201d, Royal Dutch Shell plc, March 28, 2019 (downloaded 18 May 2019: https:\/\/www.shell.com\/investors\/news-and-media-releases\/investor-presentations.html<\/strong><\/a>), slide 7. <\/figcaption><\/figure><\/div>\n\n\n\n![\"\"](\"https:\/\/valuesque.com\/wp-content\/uploads\/sites\/3\/2019\/05\/shellvalueofpostIFRS16leaseliabilities.png\")
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