New accounting rules for operating leases

Operating Leases are moving onto the Balance Sheet

One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.

– Sir David Tweedie, Former Chairman of the IASB, 25 April 2008

Once air travel resumes following COVID-19, David Tweedie can at last fulfil his bucketlist ambition, provided his chosen airline has recently reported under US GAAP or IFRS (and is still solvent …). For example he could choose Air Canada, who in their 2019 annual report state that:

… the Corporation had 127 aircraft under right-of-use leases (…), and Air Canada recorded such aircraft as right-of-use assets and lease liabilities of Air Canada in accordance with the requirements of the new standard.

New rules have recently come into force under both IFRS (IFRS 16) and US GAAP (ASC Topic 842) accounting standards, meaning operating leases are now recorded as assets and liabilities on company balance sheets. We are now seeing significant numbers of company annual reports falling under this new regime, and over the coming year this change will flow through to the vast majority of annual accounts globally, as firms complete their reporting cycle.

This note addresses the impacts of these accounting changes, and covers:

• Bringing operating leases onto balance sheets – why, how, and when
• The income statement impact under IFRS 16
• The income statement impact under US GAAP
• The current reporting cycle
• Firm-specific examples
• What is Realindex doing to reflect the change?

DW questions to address

DW: How long have existing rules been in place and what are they?

DW: How many firms are affected, how large and what sectors?

DW: Perhaps outline the extent of their use? AS: flesh out the end of next section on their typical use

Bringing operating leases onto balance sheets
– why, how, and when

Improved handling of operating leases in company accounts has been a long time coming. The significance of operating leases as off-balance-sheet liabilities first came to the limelight when United Airlines filed for bankruptcy in December 2002; their $3bn in debt was dwarfed by $7bn in operating lease liabilities for their fleet of aircraft, yet this appeared only as a footnote to their accounts.

The SEC issued tightened guidance on lease accounting in 2005¹, leading to a significant number of firms re-stating results. The guidance removed a significant amount of “wiggle room”, in particular around:

1. the term over which leasehold improvement expenses are amortised (should be the minimum of remaining lease term and the economic lifespan of the improvement);
2. accounting for the benefit of “rent holidays” (the benefit should be amortised over the lease’s life);
3. incentives from landlords, e.g. for making improvements (as in (1), should be amortised over the minimum of lease term and improvement lifespan).

The SEC guidance also specified a wide range of additional qualitative disclosures about leases that should be made in the notes, including the catchall “any unusual provisions or conditions”.

A note from Deloitte’s audit team² shortly after the guidance was published indicates another issue where leases have options to renew: it appears some firms may have used the shorter time period for some purposes (including categorisation as finance or operating) and the longer period, assuming renewal, for other purposes (such as amortising improvement costs).

The foregoing shows how leasing has historically given firms latitude to manipulate their apparent expense profile, at least compared to the rather simpler situation of direct asset ownership.

Since then there has been greater transparency of lease obligations in notes to accounts. Nonetheless, operating leases have remained a viable and widely used form of off-balance-sheet financing.

Operating vs Finance Leases

Until recently, operating leases and finance leases were subject to different treatment in company accounts.
In simple terms, finance leases are those where either:

• the present value of the leasing costs is at least 90% of the total value of the asset, or
• the lease term covers 75% of the useful life of the asset.

Leases which don’t meet either of these criteria are classified as operating leases. The new accounting rules apply to operating leases over 12 months in duration³. Obviously finance leases are named this way because the arrangement is economically very close to a mortgage financing situation, i.e. borrowing to buy an asset, while using the asset as security for the loan.

Note that under IFRS 16 the distinction between operating leases and finance leases has been removed, and they will be combined into one entry. Conversely US GAAP (ASC 842) maintains the distinction and actually specifies that operating leases should form a separate line item in balance sheets.

Previously, only the annual cost of operating leases was included in company accounts, charged to the profit and loss account under sales, general and administrative (SG&A) expenses. Yet an operating lease generally entails a set of well-defined and inescapable future payments – exactly the definition of a financial liability.

Henceforth, under both IFRS and US GAAP, operating leases will now be added to the balance sheet as a right-of-use (ROU) asset, offset against a corresponding financial liability:

Figure 1: the appearance of operating leases on balance sheets

At the inception of a lease, the ROU asset and its corresponding financial liability are equal in magnitude - this is precisely how the value of an ROU asset is determined. The liability side is treated as a conventional financial liability, and its net present value is calculated using an appropriate discount rate (the firm’s marginal borrowing rate). The new approach gives a fairer picture of the balance sheet. Among other things:

• The lease liability will now correctly be included in the total liabilities of the firm.
• Total assets are increased by the value of the ROU asset, and this will rightly impact metrics such as ROA by increasing the size of the asset pool over which returns are measured.
• The new treatment also leads to a more balanced comparison between leasing an asset and borrowing the capital to buy it outright – this may lead to a greater tendency towards buying assets in future.

It took many years of discussion by the accounting standards boards (IASB and FASB) to agree and implement this revised approach, and it is now in force for accounting periods starting on or after 1 January 2019 (a couple of weeks earlier for US GAAP). This means that under both standards the new lease accounting approach is mandatory for financial years ending 31 December 2019 onwards.

The income statement impact under IFRS 16

The treatment of operating leases on income statements will differ quite significantly between IFRS (under IFRS 16) and US GAAP (under ASC 842).

As noted above, under IFRS there will no longer be a distinction between finance and operating leases – effectively both sorts of lease will now be treated as finance leases. Conversely, under US GAAP there will continue to be a different handling of finance and operating leases. The classification criteria aren’t simple, but guidance from the previous standard (ASC 840) is indicative: it is a finance lease if the payments through its life are more than 90% of the asset’s value, or if the lease term is more than 75% of the useful life of the asset, otherwise it is an operating lease.

Under IFRS 16, operating lease expenses have moved down the income statement from Selling, General, and Administrative expenses (SG&A) and will be split into a lease amortisation expense and a lease interest expense, falling under depreciation & amortisation and financing costs respectively. This is neatly captured in the following diagram provided by the IASB:

Figure 2: Income Statement impact of moving to IFRS 16.
Source: “IFRS 16 Leases, Effects Analysis”, IASB, Jan 2016“.

Under IFRS there is a difference in how the asset and liability part of a lease are modelled on their way to zero as time passes (recall that they start off equal, as this is how the ROU asset value is determined):

• The lease liability is treated similarly to a simple bond valuation, and is modelled using an NPV approach with a single discount rate (approximating the marginal borrowing rate of the firm). This leads to a higher interest cost near the start and a lower cost towards the end of a lease.
• The ROU asset uses straight-line amortisation, and thus the lease amortisation cost is effectively the same (in nominal terms) for each year of a lease’s life.

Here is a simple worked example under IFRS 16 :

Figure 3: an illustrative example of a single lease under IFRS 16, based on a $10 annual lease payment for 7 years with an assumed marginal borrowing cost of 3%.
Source: Realindex research team.

This example shows that:

1. We take the NPV of each future lease payment, shown in the third column, and sum these to give the NPV of the total liability (first row of fifth column).
2. This is then taken to be the value of the ROU asset at the start of the lease (first row of fourth column). The ROU asset value is straight-lined to zero over its lifetime (fourth column), i.e. one seventh of its initial value is deducted each year.
3. These deductions are recorded as lease amortisation expenses in the income statement (seventh column).
4. The lease liability NPV is recalculated each year (fifth column). Note that this liability decreases by less than the annual $10 spend on leasing, due to the shortening term of the remaining liability.
5. The difference is interest expense which is recorded in the financing part of the income statement (eighth column).

The overall impact to expenses compared to the previous accounting treatment is shown in the last column: effectively it results in a front loading of lease costs due to the interest calculation. A chart provided by the IASB confirms this effect:

Figure 4: the impact of moving to IFRS 16 on lease expenses over time.
Source: “IFRS 16 Leases, Effects Analysis”, IASB, Jan 2016.

Impact of this change on common financial ratios.

The impact here on financial ratios is material, particularly those that are affected by the relocation of the expenses further down the income statement. The main impacts are:

• EBIT increases, since some of the lease costs that were previously deducted from “E” move into “I” and thus are omitted.
• EBITDA increases even more, because the amortisation part of lease expenses – usually larger than the interest part – move down into “DA” and thus is also excluded.
• There is also an increase in the size of the balance sheet, so metrics like return-on-assets, debt-to-equity, and enterprise value (EV) will naturally be impacted too.

The income statement impact under US GAAP (ASC 842)

US GAAP (ASC 842) requires operating lease expense to be included as an expense alongside income from continuing operations; thus in general it will likely end up in Selling, General & Administrative expenses. Generally lease amortization and lease interest expense will be consolidated into a single lease expense.

DW: How is this different to IFRS?

This section need to be written!!

The current reporting cycle and firm-specific examples

The following table shows the counts of IFRS firms in the Realindex global universe which have reported annual results for year-ends on or after 31 December 2020:

As at 29 Feb 2020

Firm Counts Table HERE.

From this table we can see that preliminary accounts tend not to provide lease expense details, but within final accounts the lease amortization expense is provided for three quarters of the universe. Lease interest expenses are provided for a little over half the universe.

Lease expenses are non-negligible, for example the largest 10 firms by lease amortization expense in our global universe are shown in the following table. Lease costs are a very significant proportion of total operating income, averaging 48% across this sample of large firms.

What is Realindex doing to reflect the change?

In the absence of any adjustment, the new accounting treatment of leases would effectively remove these leasing expenses from the cash flow measure we use in our core portfolio weighting process, since it excludes both depreciation and amortization and financing costs. In our process this would lead to significant up-weights to high lease-cost firms which would gradually roll into our core weights over the course of the next five years.

We have therefore made two changes to our process based on the new lease amortization expense:

• We now deduct lease amortisation expense from our core cash flow measure;
• We also deduct lease amortisation expenses from the EBITDA and CFOA metrics that are used in enhancements.

We did not make any changes based on the lease interest expense, for three reasons:

• It has rather poor coverage (it is often not broken out in annual reports).
• It is heavily influenced by the tenor of leases (which is not obviously a desirable outcome).
• It is generally a much smaller part of the overall leasing expense.

As an aside, at least one financial data provider that we are aware of has taken a comparable approach and refined metrics like EBITDA in an analogous way.

Conclusion

In summary:

• Operating leases are coming onto balance sheets for both IFRS and US GAAP, with the NPV of a lease liability offset by a right-of-use (ROU) asset.
• Under IFRS: lease amortization is a straight-line cost and interest costs are front-loaded.
• Under US GAAP: total lease cost is straight-lined, the ROU asset is re-valued each year to match the NPV of liabilities, and lease interest takes up the slack.
• These changes apply to most annual reports published Feb 2020 or later⁴.
• We have deducted lease amortization expense from our core cash flow metric, and from the EBITDA and CFOA metrics in our enhancements model.

Bibliography

A selection of references used in compiling this report:

AASB 16, “Leases”. Australian Accounting Standards Board (AASB), Feb 2016.

IASB, “IFRS 16 Leases Effects Analysis”. International Accounting Standard Board (IASB), Jan 2016.

PwC “Leases”, December 2018.

PwC, “IFRS and US GAAP: similarities and differences”. October 2019.

David Tweedie, “The Importance of International Accounting Standards”. Speech to the Empire Club of Canada, 25 April 2008. http://speeches.empireclub.org/65982/data?n=1.

Peter Wuchatsch, “AASB 16 & the pitfalls of using EBITDA”. Ownership Matters, 15 May 2019.

Glossary of Terms

AASB 16 – Australian Accounting Standards Board rule 16, the Australian counterpart of IFRS 16
ASC 842 – Accounting Standards Codification 842, the new lease accounting standard under US GAAP published by FASB
EBITDA – Earnings Before Interest, Tax, Depreciation, and Amortisation
EV – enterprise value, commonly taken to be the sum of shareholders’ equity and debt less cash
FASB – Financial Accounting Standards Board, www.fasb.org, the organisation which sets U.S. accounting standards (US GAAP)
IASB – the International Accounting Standards Board
IFRS – International Financial Reporting Standards, <www.ifrs.org>
IFRS 16 – the new leases accounting standard under IFRS
ROU asset – Right Of Use asset, an asset representing the economic value of the usage rights conferred by a lease
SGA - Selling, General, and Administrative expenses
US GAAP - U.S. Generally Accepted Accounting Principles, determined and promulgated by FASB