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How Do The New Lease Accounting Standards Affect Your Assessment Of Credit Risk?


How Do The New Lease Accounting Standards Affect Your Assessment Of Credit Risk?

Highlights

The impact of IFRS 16 and ASC 842 on our Credit Analytics models

IFRS 16 and ASC 842 are new accounting standards that govern recognition, presentation, and disclosure of leases, and became mandatory for reporting periods beginning on or after January 1, 2019.[1],[2] IFRS 16 is the new standard for companies reporting under the International Financial Reporting Standard, and ASC 842 applies to companies reporting under the United States’ Generally Accepted Accounting Principles (US GAAP).[3],[4] These new standards require all leases to be reported on the balance sheet as assets and liabilities, including operating leases that previously were not captured on the balance sheet.[5] Also, companies will no longer classify their leases between operating and finance leases under IFRS, but will continue to do so under US GAAP.[6]

Depending on the industries that you have most exposure to, there will be differing impacts of these reporting standards on the financials and credit risk of your counterparties and investments. In this article, we summarize the expected impact of these new accounting standards on financial statements, and discuss how the standardization of company financials will be adjusted on the S&P Capital IQ platform (CIQ platform) to maintain comparability across companies. Finally, we present some of the results of our preliminary analysis of the impact of new accounting standards on our Credit Analytics’ suite of statistical models.[7]

New financials – standardizations and new data items

The new accounting standards will affect a number of company’s financials, and the changes may be significant for companies with a larger proportion of operating leases.[8] Moreover, this change may be different for companies reporting under IFRS versus GAAP.

To increase comparability of company financials, the CIQ platform adopts a standardization policy that homogenizes reported values across the two standards. In addition, to support reconciliation of IFRS and GAAP financials (especially for companies with dual reporting), several data items have been added to the CIQ platform’s fundamentals offering. A detailed discussion of the material impacts on the CIQ platform’s standardized financial statements and the additional data items is available in the S&P Global Market Intelligence “CIQ Fundamentals Update – Operating Leases” (August 2019).

Financials impact of new lease accounting

The International Accounting Standards Board (IASB) estimates that approximately $3 trillion USD in leases will be recorded on company balance sheets over a period of several years.[9] Since companies have only recently started to adopt the new accounting standards, there are still limited financials available in order to perform a full impact analysis.

Therefore, in the light of these limited financials, we analysed our CreditStats® Direct database that includes both unadjusted (as reported) financials and S&P Global Ratings credit risk analysts’ adjusted financials (including adjustments for operating leases).[10] For example, our analysis shows that the most impacted industries will be Retail, Transportation (including Airlines), and Telecommunication Services. The median aggregate increase in total assets is expected to range between 8% and 23%, while total debt will increase between 12% and 48%.[11]

Impact on credit risk assessment

Our Credit Analytics product suite offers two types of fundamentals-driven statistical models to assess credit risk: CreditModelTM (CM) and Probability of Default Model Fundamentals (PDFN).[12] The former is a credit scoring model that aims to statistically match the S&P Global Ratings issuer credit ratings for large-revenue rated companies, and can also be applied to unrated (financial and non-financial) corporations, globally.[13] The latter generates a PD, its related term structure from one month to 30+ years, and the associated credit score for public or private non-financial companies, globally.

The capitalization of operating leases will have an impact on companies’ financials and, thus, on any fundamentals-driven statistical model that uses financial ratios to estimate a company’s creditworthiness. With the adoption of the new accounting standards, it is important to understand how these changes may affect the statistical model’s inputs and outputs.

In essence, not all ratios are expected to deteriorate/improve at once from a financial standpoint. Moreover, for many ratios it is not possible to determine a priori the expected directional change. In turn, the corresponding change of the model score will depend on the magnitude/interplay of input changes, since opposite contributions by competing ratio changes will tend to be offset.

Case Study

Air France-KLM SA (“Air France”) is one of the companies that restated their historical financial statements in line with IFRS 16. Table 1 shows a section of Air France’s FY 2017 financial statements standardized before and after the IFRS 16 adjustments. The impact is considerable, and the majority of the financial items change by more than 20% after the operating leases are capitalized. For example, total liabilities increase by almost 30% and total assets by 23%.

Table 1: PDFN’s financial items reported by Air France’s for FY 2017, before and after the IFRS 16-related restatement. The colour refers to the financial implication (green for positive impact, red for negative impact).

Financial Input

Original

(mil EUR)

Restated

(mil EUR)

Change (%)

EBIT

1,586

2,021

27

Interest Expense

-184

-519

182

Total Revenues

25,784

25,867

0

Total Revenues (prior year)

24,846

24,846

0

Cash from Operations

2,898

4,099

41

Total Assets

24,408

29,963

23

Income Tax Expense

-229

21

109*

Net Income

274

163

-41

Net Property Plant and Equipment

11,413

16,778

47

Retained Earnings

-189

248

131*

Total Cash and Short-term Investments

4,715

4,808

2

Total Current Liabilities

11,045

12,054

9

Total Liabilities

21,393

27,543

29

Total Equity

3,015

2,420

-20

Note: Due to the difficulty in calculating the percentage change of a number moving from a negative to a positive value, we apply the following convention: 1 + Absolute (ABS) (21/-229), where ABS refers to the absolute value of the ratio in brackets.

Source: S&P Global Market Intelligence. As of August 28, 2019. For illustrative purposes only.

Figure 1 shows the outputs generated by PDFN. The left and right panels use financial ratios for FY2017 calculated with original and IFRS 16-compliant financials, respectively. Most model parameters deteriorated from a financial standpoint, albeit not significantly, whereas Total Assets shows a marked increase. As a result, the credit score deteriorated by only one notch under the IFRS 16-compliant financials, with Cash from Operations/Net Income being the only driver whose contribution increases significantly.

Figure 1: PDFN’s outputs for Air France, using original (left) and IFRS 16-compliant (right) financial inputs for FY2017.

Original

Restated

Source: S&P Global Market Intelligence, as of August 28, 2019. For illustrative purposes only.

 

Conclusions and Recommendations

The new accounting standards for operating leases pose several challenges at the reporting level, requiring careful consideration of IFRS and GAAP nuances in order to enable effective financials reconciliation for corporations subject to dual reporting.

The S&P Capital IQ platform includes an updated financial standardization policy that enables operating leases to be treated consistently, and in line with capital leases. In addition, several supplementary items have been added to facilitate and support comparative analysis under IFRS and GAAP standards.

As companies start reporting (and restating past) financial statements according to the new accounting requirements, we expect company financial ratios to move in both directions. A preliminary analysis conducted on a database of company financials adjusted for credit risk analysis (including the capitalization of operating leases) shows that, in more than 90% of the cases, the outputs of the Credit Analytics fundamentals-driven models remain within one notch from the outputs obtained using unadjusted financials.[14]

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[1] IFRS 16 replaced IAS 17 and is the new standard on lease accounting for companies reporting under the International Financial Reporting Standards. ASC 842 replaced ASC 840.

[2] IFRS16 became mandatory for annual reporting periods beginning on January 1, 2019; ASC842 became mandatory for public business entities for calendar periods beginning on January 1, 2019, and for all other entities for periods beginning on January 1, 2020.

[3] Source: “IFSR16 Leases”, International Accounting Standards Board, accessed August 28, 2019, https://www.ifrs.org/issued-standards/list-of-standards/ifrs-16-leases/

[4] Source: “ASC 842 – Leases”, Financial Accounting Standards Board, accessed August 28, 2019, https://www.iasplus.com/en-us/standards/fasb/broad-transactions/asc842.

[5] This excludes short-term (i.e., less than 12 months; no purchase options) leases under both IFRS 16 and ASC 842, and low-value assets (i.e., less than US $5,000) under IFSR 16.

[6] KPMG: “IFRS 16 and ASC 842 differences”, (accessed August 28, 2019), https://advisory.kpmg.us/articles/2018/ifrs-16-asc-842-differences.html.

[7] S&P Global Market Intelligence’s Credit Analytics suite of statistical models includes data, analytics, and workflow tools that can be used to assess and monitor the creditworthiness and loss profile for millions of companies and exposures.

[8] CFA Institute: “Leases: What investors need to know about the new standards”, 2019.

[9] S&P Global Market Intelligence: “CIQ Fundamentals Update – Operating Leases”, August, 2019.

[10] S&P Global Market Intelligence CreditStats® database contains financials for companies rated by S&P Global Ratings and is available within the CIQ platform. As of September 1, 2019, the dataset includes 1,200+ rated non-financial corporate companies, globally, and spans the reporting period from 2013 to 2018.

[11] S&P Global Market Intelligence: “Lease Accounting Under IFRS 16 and ASC 842– Impact Analysis on Credit Analytics Statistical Models”, November, 2019.

[12] S&P Global Market Intelligence also offers a market-driven model, PD Model Market Signals, which includes total liabilities as one of its inputs. In this case, we do expect a general deterioration of the overall credit risk profile of companies that will see a significant increase in their debt levels due to capitalization of operating leases, but we do not expect major changes in ranking power of the model. Nevertheless, we will keep monitoring model performance during the annual backtesting procedure, and will take further steps should the performance deteriorate beyond acceptable levels.

[13] S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit model scores from the credit ratings issued by S&P Global Ratings. 

[14] S&P Global Market Intelligence: “Lease Accounting Under IFRS 16 and ASC 842– Impact Analysis on Credit Analytics Statistical Models”, November, 2019.

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