A company can either buy or rent (lease) an asset. Why would a company choose to rent vs. own? There are many reasons to rent, but chief among them would be less upfront capital required and flexibility to change with technology. In capital intensive industries, companies tend to lease their assets rather than owning them outright: Airlines typically lease their airplanes; Retailers rent their locations; And construction companies lease their equipment.
Under the old leasing rules, depending on the terms of the lease, some leases were on the balance sheet as a liability (capital or finance lease) and some leases were off balance sheet (operating lease).
Operating leases were therefore a form of off-balance sheet financing. Financial statements didn’t properly capture the obligation implicit in an operating lease. An operating lease payment represents a contractual commitment similar to principal and interest payments on debt.
The previous classification of leases had significant effects on financial metrics. Similarly sized companies in similar businesses could have had very different EBITDA margins, Return on Assets/Invested Capital or Debt to Capitalization calculations depending on their mix of capital leases vs operating leases or outright ownership of fixed assets.
The current leasing rules took effect for reporting periods starting after December 31, 2018 under both IFRS and US GAAP.
Summary of Current IFRS and US GAAP Lease Accounting Standards
IFRS 16
US GAAP
Under IFRS, all leases are considered to be finance (i.e. capital) leases.
Assume a company (lessee) enters into a five-year lease with the following lease payments:
Year 1: $100,000
Year 2: $110,000
Year 3: $115,000
Year 4: $115,000
Year 5: $100,000
The lessee’s incremental borrowing rate is 8%. The lessee’s incremental borrowing rate is defined in IFRS 16 as “the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment.”
Balance Sheet Impact
Discount the lease payments back to the present using either the interest rate used by the lessor OR the lessee’s incremental borrowing rate (in most cases, you would never know the lessor’s rate). The present value of the discounted payments appears on the lessee’s balance sheet as an asset (right-of-use asset) and as a liability (lease liability).
Income Statement Impact
Use the incremental borrowing rate to calculate interest expense. Depreciate the “right-of-use asset” over the term of the lease. For our example, we will use straight-line depreciation. Under the former IFRS lease rules (IAS 17), operating lease expense would have been recognized as rent expense on a straight-line basis over the lease term. The total expense on the income statement over the course of the lease is the same as under previous IFRS accounting standards. The only difference is timing.
Cash Flow Statement Impact
Add back depreciation to cash flow from operations and deduct the principal payments (lease payment minus interest component) from cash flow from financing. In some cases, the interest components of the lease payment might be reclassified from Operating Activities to Financing Activities on the cash flow statement.
Assume a company (lessee) enters into a five-year lease with the following lease payments:
Year 1: $100,000
Year 2: $110,000
Year 3: $115,000
Year 4: $115,000
Year 5: $100,000
The lessee’s incremental borrowing rate is 8%.
Balance Sheet Impact
Discount the lease payments back to the present using either the interest rate used by the lessor OR the lessee’s incremental borrowing rate (same method as IFRS). The present value of the discounted payments appears on the lessee’s balance sheet as an asset (Right-of-use Asset) and as a liability (Lease Liability).
Income Statement Impact
Lease expense is a single line in operating expenses on a straight-line basis (the total lease expense over the term of the lease divided by the number of years). This is unchanged from legacy U.S. GAAP operating lease treatment.
The “Right-of-use Asset” is depreciated by a number that is “backed into” by subtracting the calculated interest cost from the straight-line lease expense. The depreciation of the right-of-use asset is increasing from the start of the lease to the end of the lease, but the total rent expense on the Income Statement over the course of the lease is the same each period.
Cash Flow Statement Impact
The only impact is to Cash Flow from Operations.Add back the straight-line lease expense from the income statement and deduct the actual lease expense for the period.
Assume a company (lessee) enters into a five-year lease with the following lease payments:
Year 1: $100,000
Year 2: $110,000
Year 3: $115,000
Year 4: $115,000
Year 5: $100,000
The lessee’s incremental borrowing rate is 8%.
Balance Sheet Impact
Discount the lease payments back to the present using either the interest rate used by the lessor OR the lessee’s incremental borrowing rate (same method as IFRS). The present value of the discounted payments appears on the lessee’s balance sheet as an asset (Right-of-use Asset) and as a liability (Lease Liability).
Income Statement Impact
Use the Incremental Borrowing Rate to calculate Interest Expense. Depreciate the “Right-of-use Asset” over the term of the lease. In this example, we use straight-line depreciation.
Cash Flow Statement Impact
Add back depreciation to Cash Flow from Operations and deduct the Principal Payments (Lease Payment minus Interest Component) from Cash Flow from Financing.
The key difference that needs to be considered is that EBITDA will be very different between the two companies. To compare EBITDA, you will need to add back lease/rent expense to EBITDA for U.S. GAAP companies.
On the balance sheet, it’s important to note that for U.S. GAAP companies, operating lease liabilities will be disclosed separately from debt and therefore need to be added to total debt in order to be comparable to IFRS companies.
It’s also important to remember that year-over-year comparisons could be difficult for certain companies. Under IFRS and U.S. GAAP, companies are not required to restate prior years’ balance sheets or income statements, although they may choose to do so. They can make an adjustment to opening equity for the start of the period in which they adopt the new accounting for leases. Be sure to read the notes to the financial statements and the Management’s Discussion and Analysis (MD&A). Of course this becomes less relevant over time.
