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IFRS 9 and 16: Fake changes with real consequences

By Owen Sanderson
26 Feb 2019

Even credit geeks relegate accounting geeks to the back corners of the classroom. It’s proverbially dry, and shouldn’t affect real world issues, such as whether a company can deliver returns for its shareholders and pay its debts. But seemingly esoteric accounting changes can mean major real world consequences. It’s not just for the geeks; it’s time to get real about IFRS.

At the start of this year, new lease accounting rules called IFRS 16 came into force, with huge consequences for corporates of all kinds.

Leases will be capitalised, and the only portion of leases flowing through the P&L will be depreciation and interest expenses. Crudely, that means bigger balance sheets, but higher earnings, too.

Businesses leasing out aircraft or rolling stock or other capital equipment have seen huge balance sheet changes; retailers with big lease liabilities, or supermarkets that sold and leased back their stores, also see changes.

The changes were well flagged — accountancy firms started to circulate documents explaining how it would work in 2016, and jumped up and down to interest corporate treasurers and bankers in the review — but only mid-way through last year did activity to deal with the new rules ramp up to a meaningful level. Bankers looked again at their lending covenants, while treasury teams started to review their businesses to see how to manage the new reporting standards.

Not quickly enough. Certain issuers that were likely to see huge effects — Tesco, for example, with a string of sale-and-leaseback trades on its supermarket portfolio — had said nothing as late as their full year reports.

The market for bank equity and debt has been through a cycle that looked much the same, with the introduction of IFRS 9 at the beginning of 2018. This introduced “expected credit loss” accounting, essentially bringing forward losses associated with the deterioration of credit quality.

Once a loan’s prospects were downgraded from pristine (stage 1) to the level below (stage 2), banks had to take provisions against not just losses expected in the next year, but losses across its lifetime. So a big macro downturn means banks take more provisions up front, leading to more volatility in bank P&Ls and capital levels.

It also affected fair value accounting for financial instruments, introducing a test called “solely payments of principal and interest” to sort the fixed income sheep from the goats — with major consequences for certain kinds of investment portfolio.

Accountancy firms, more enlightened FIG banks, and the better financial journalists had been warning that the change had serious consequences from 2014 — but issuers and investors took a long time to wake up, and regulators only rushed through a package of measures to soften the impact late in 2017.

In both cases, investors looking at fundamental quality of a business have reasons to ignore this kind of accounting change.

Listen up

As Wu Tang Clan once said, “cash rules everything around me” — and looking through the funhouse mirror of accountancy to see what cash comes in through the real operating business, and goes out through real dividends, is usually a worthwhile exercise. Which particular accounting prism one uses, shouldn’t, in theory, make much difference to whether a business is doing well or badly, whether it can service its debt, or whether it delivers for shareholders.

But the problems come when the abstractions of accounting start to feed into real world targets.

Regulators leapt to ‘solve’ the problem of IFRS 9 in banks when it became apparent that the change could force a bank to breach its (equally arbitrary) required capital ratios.

A bank with a weak loan portfolio facing an economic downturn might be a poor business in some respects, but looking at it through a different accounting lens doesn’t change anything real about it.

Except that breaching supervisory requirements would force regulators to step in, demand changes from management, extract a turnaround plan, and perhaps even force the bank into the arms of the state. A weak enough capital ratio, however calculated, might even trigger capital instruments.

Lease accounting comes with the same problem when it meets the real world. Loans bankers were aware, last year at least, that IFRS 16 would potentially lead to wild shifts in crucial credit metrics such as total indebtedness and Ebitda, and sought solutions.

Both the solutions to the accounting changes, though, share similar flaws. Much of the loans market settled on “Frozen GAAP”, as a way to handle the changes — but this simply attempts to ignore the new accounting schema and continue with the old generally accepted accounting principles, so as to avoid monkeying around with existing covenant packages.

In high yield, where it’s harder to amend bond terms, there may be no solution at all — and some issues have documentation so loose that an unscrupulous issuer can use the IFRS 16 figure where it suits, or the old figure where it does not, potentially allowing them to boost indebtedness beyond the original intentions of the documents, or pay out larger dividends to sponsors.

The solution on the banks side was similarly weak. European regulators figuring out how to ease the pain for banks struggling with IFRS 9 allowed them to simply reverse the changes for regulatory purposes. For the first year it was in place, 2018, banks could subtract any IFRS 9-related effects from their regulatory calculations, while this year they will be able to subtract 80%.

GlobalCapital certainly isn’t enough of an accounting geek to opine on the superiority or otherwise of the new methods — every accounting view has certain positives and negatives — but IFRS 9 and 16 are here to stay.

Like it or not, these will be the dominant lenses through which we have to view balance sheets and income statements in the future, and that means the market ought to handle them properly. Perhaps that will mean different covenant structures, more flexibilitybetter hedges for economic downturns, or other real world changes.

But it’s a more responsible way to handle change than simply trying to ignore it. Time markets grew up.

By Owen Sanderson
26 Feb 2019