Sometimes, it’s the small things that have the biggest impact. Forcing companies to adopt more transparent accounting has in the past led to major changes in corporate behaviour. Defined benefit pensions are now an endangered species, largely because the real economic cost is laid bare for all to see.
One of the smaller changes in IFRS 18 is that the cashflow statement will now start with operating profit and not with net income. At a stroke, this fixes one of my three complaints about the current cashflow statement. All that remains is to fix the other two: where the statement ends and most of what happens in between.
I think there is an obvious place to end the cashflow statement: with the movement in net debt. It may not be a GAAP term, but many companies use net debt as a key performance indicator (aka KPI), and as such it is likely to be audited as a ‘management-defined performance measure’ under IFRS 18.
I am hopeful that this small change will trigger a minor revolution in cashflow reporting
Leaving aside the predictable but disappointing decision to invent a new acronym – what was wrong with KPI? – I am hopeful that this small change will trigger a minor revolution in cashflow reporting. Reconciling operating profit to net debt is such an obvious step that it will, I hope, become widespread.
The meaning of debt
All this led me to reflect on what net debt actually means. At first sight it’s obvious: debt and quasi-debt instruments less cash and equivalents. But when you start digging further, the story becomes more complex, especially when you look at leases.
One of the favourite jokes of Sir David Tweedie – the former chairman of the International Accounting Standards Board (IASB) – was that he hoped to someday fly on an aeroplane that was on a balance sheet somewhere. This eventually led to IFRS 16, Leases, which requires lessors to capitalise both a right-to-use asset and an associated lease liability, roughly the same as the sum of all future lease payments.
Using British Airways parent IAG as an example, we see that it had net debt at the end of 2023 of £9,245m, of which £8,967m were lease liabilities, mainly for aircraft. Aircraft are technically fixed assets despite being inherently movable. To a non-accountant like me, leasing an aircraft for, say, 20 years is conceptually the same as a long-term rental. There will be options to terminate the lease early or to sub-lease the aircraft to someone else. There may be a cost with early termination or sub-leasing, but the £9bn ‘debt’ is not really debt in my mind. It is very different to having an outstanding bond or an unfunded pension liability.
The decision to lease is based on the need for a flexible cost base; it’s not a financing issue
Commercial value
Leasing aircraft is an operating cost for an airline, not a borrowing transaction. The number on the lease can be flexed and there is an associated asset, which has real commercial value. The decision to lease is based on the need for a flexible cost base; it’s not a financing issue.
At the time of writing, IAG has a market capitalisation of about £10bn, so how one treats the lease debt has a huge impact on the implied valuation. Stripping out the aircraft lease liabilities from net debt almost halves any enterprise value-based valuation multiple.
This brings me back to the cashflow statement. As a general rule, I think that lease liabilities should not be treated as part of net debt. I make an exception for leased assets that are inflexible, such as a car-assembly plant.
The IASB launched a review of the cashflow statement ‘and related matters’ on 16 September. I think this is by far the most important issue on the IASB’s to-do list. It should include a review of what ‘net debt’ really means.
More information
See Peter’s previous columns that touch on related topics: ‘IFRS 18 needs to deliver’ and ‘Fixing cashflow reporting’; and thoughts from technical expert Adam Deller ‘Replacement plans for IAS 1’ and ‘Preparing for IFRS 18’
In addition, ACCA’s annual virtual conference, Accounting for the Future, includes a session on IFRS 18. In the session ‘Upskilling for changes in IFRS presentation and disclosure’ (28 November), you can hear from the International Accounting Standards Board about the drivers behind these new standards and how users of financial statements will benefit from the new information. Our panel of experts will then analyse the practical implications. Register to watch live or on demand.
