Operating leases: You may still need to adjust

Do you invest in both IFRS and US GAAP reporters? If so, then in recent financial statements you might have noticed differences in the accounting for leases. This could result in a significant lack of comparability in key metrics.

Both IFRS and US GAAP now better reflect the economics of leasing and so the old adjustments to capitalise operating leases are no longer necessary. Unfortunately, you now need to make other adjustments to get comparability between US and IFRS reporters. We explain the adjustments and provide an interactive model to help.

From 2019 investors benefit from an improvement in both IFRS and US GAAP lease accounting with the more comprehensive recognition of lease liabilities ‘on balance sheet’. The majority of you will likely welcome this change as it eliminates the need for the operating lease capitalisation adjustments made by many investors. However, what is not so welcome is that the new standards are not fully converged.

Unlike recent changes to revenue recognition, where the differences between IFRS and US GAAP are small, the lease accounting divide is significant and pervasive. If the new lease liabilities reported in financial statements are material you will almost certainly need to make adjustments to be able to compare IFRS reporting companies with their US peers.

The differences affect EBITDA, EBIT, margins, shareholders’ equity, return on capital and enterprise value based multiples.  Depending on circumstances, they can also affect net income and EPS. In addition, although there is no change in cash movements, the classification of leasing flows in the cash flow statement is also different, thus impacting cash flow subtotals, notably operating cash flow.

The good news is that the balance sheet lease liability will (mostly) be the same under US GAAP and IFRS. There are differences in the scope of which leases are capitalised and in their measurement, but the effect of these will generally be minor.

Lease accounting: IFRS 16 versus US GAAP

Under IFRS there is a single accounting approach to all leases, with the old distinction between operating and finance leases eliminated. Operating leases are now capitalised, producing a lease liability and corresponding lease asset called the ‘right of use’ asset. Normal fixed asset accounting is applied to the asset and normal liability accounting to the lease obligation. Of course, there is more to it than that and certain leases, such as those that are short term or of low value assets, may not be capitalised, but in essence it is a single approach.

Old operating lease accounting is in part retained under US GAAP

US GAAP does it differently; it retains the old distinction between finance (previously called capital leases in US GAAP) and operating leases. There is no change to finance lease accounting, which remains converged with IFRS. It is the operating leases that are accounted for very differently. While these leases are capitalised in the balance sheet, just as for IFRS, the old operating lease accounting is maintained in both the income statement and cash flow statement. This means that under US GAAP a single lease expense is recognised as an operating cost, usually on a straight-line basis over the lease term (just as previously). However, IFRS replaces the old operating lease expense with depreciation of the right-of-use asset and interest accretion related to the lease liability. EBITDAR (the ‘R’ being lease rentals) will be the same under IFRS and US GAAP. Other metrics, notably EBITDA and EBIT, could be very different.

If it were only the presentation of EBIT and EBITDA that was impacted by the GAAP difference, it would not be too bad for investors and it would be relatively easy to convert metrics from US GAAP to IFRS. However, the single versus dual classification approach has other implications. Because the total lease expense under IFRS is likely to be front-loaded, whereas the US GAAP single lease expense is straight line, there is also a subsequent measurement difference. This impacts the right of use asset and shareholders’ equity and potentially (depending on the rate of growth of leasing activity and the related maturity of the lease portfolio) net income and EPS. For more about the front-loading effect and the impact of transition to IFRS 16 see our article: Leasing – Are your prepared for IFRS 16?

After initial recognition of a lease, at which time US GAAP and IFRS are the same, the IFRS right of use asset will tend to be lower than the liability, but the US GAAP asset will generally be equal to the liability, unless other complicating factors are present such as rent-free lease periods or asset impairments. In effect, under US GAAP the asset is depreciated (although no depreciation actually appears in the income statement) on a non-linear basis to match the non-linear reduction in the lease liability.

For cash flow, the single operating lease expense under US GAAP is reported as an operating cash flow. However, under IFRS the lease cash flow is split into a liability repayment component, presented as a finance cash outflow, and an interest payment which may be presented as either an operating flow or a financing flow. Total cash flow is the same under both systems but subtotals, notably operating cash flow, will differ. For more about analysing lease related cash flows see our article: In search of free cash flow – Amazon

Making adjustments to cash flow to obtain comparability should be relatively easy. Our discussion below focuses on the income statement and balance sheet, where things are more challenging.

The problem is the inconsistency in US GAAP

Confused and annoyed there is a GAAP difference? In our view the problem is the inconsistency that US GAAP introduces between the balance sheet and the income statement. In the balance sheet, operating lease capitalisation results in a fixed asset and related financing liability. However, in the income statement there is neither depreciation nor interest, but instead the old lease expense. We do not think this is logical.

Inconsistency between US GAAP balance sheet and income statement creates analytical challenges

One potential consequence of this inconsistency is that key metrics, such as rates of return on capital and enterprise value multiples for US GAAP reporters, may be incorrectly calculated by some investors. For both return on capital and multiples such as EV/EBIT it is vital that the numerator and denominator are consistent. If a source of finance is regarded as part of the financing structure and hence included in enterprise value and capital employed (i.e. not deducted in calculating net assets) then the profit metric used in the ratios must be stated before deducting the cost of that finance. For more about this issue see our article EV/EBITDA multiples must be consistent – Novartis.

The problem with the US GAAP approach for investors is that it will be tempting to include the lease liability as part of financing. This is fine, and indeed in our view the right thing to do. However, consequently you should adjust operating expenses to remove the interest cost related to that financing from the lease rental expense. If you don’t want to adjust EBIT under US GAAP then treat the lease liability as an operating liability instead, just as, for example, you would treat trade payables.

So what should you do?

The good news is that if you are analysing just IFRS financial statements (or indeed only US companies) then the answer is you don’t need to do anything. All metrics will be comparable. Of course, for IFRS they will differ from pre-IFRS 16 days, but the new accounting is a better representation of the economics. For US companies you will also get new information, in the form of a realistic operating lease liability, although, as we note above, you need to be careful when computing analytical metrics.

However, if you are comparing IFRS reporters with US companies then you have a problem. For many companies the impact will be small and you can ignore it (but you need to check). Where it does matter we think you have three approaches:

Do nothing

If you make no adjustment for the GAAP difference then you may not actually be in much worse a position than you were under the old accounting. Previously you had a comparability problem with some companies purchasing assets and others acquiring similar assets under operating leases. While adjustments were common, many investors did not bother. Not adjusting is not ideal, but as long as you are aware of the potential difference when interpreting key metrics then mistakes can be avoided. However, remember not to treat the US GAAP lease liability as financing for the purpose of returns or valuation multiples.

Make simplified adjustments to US financial statements

The most significant difference relates to the presentation of the lease expense in the income statement, so if you are going to adjust anything it makes sense to start here. The easiest approach is to reclassify the US GAAP single lease expense into partly depreciation and partly interest, but without attempting to adjust the total.

Estimate the interest cost by multiplying the balance sheet liability (best to use an average) by the disclosed weighted average discount rate. The depreciation of the right of use asset is then the remainder of the lease rental expense.

Under this approach we don’t try to reflect the IFRS front loading effect that impacts many metrics, including shareholders’ equity or net profit. If leases are relatively short-term this probably does not matter, even if the use of leasing is significant. However, for long-term leases, particularly where the discount rate is high and there is high growth, just using this approach may not be enough.

Make more comprehensive adjustments

In practice the right of use asset under US GAAP will almost certainly be higher than the equivalent under IFRS. As a consequence, IFRS shareholders’ equity will be lower. You could estimate the effect by comparing the right of use asset as reported with what it would have been under normal straight-line depreciation. If you are familiar with depreciation methods it is the difference between annuity depreciation and straight-line depreciation. Long leases and high interest rates exacerbate the difference. Under US GAAP there is a required disclosure of the weighted average lease term. This, along with the weighted average discount rate, are your key inputs.

The other aspect of the difference in the right of use asset measurement is that it can also affect net income and EPS. However, this only happens to any significant degree if there is significant growth (or decline) in the use of lease financing. For a company at ‘steady state’ IFRS and US GAAP will produce the same net income and EPS.

Our conversion model uses this more comprehensive approach. But, as we note, there are still simplifying assumptions.

Unfortunately, accurate restatement is impossible

There is no way for an outside investor to make US GAAP and IFRS financial statements perfectly comparable with regard to lease accounting. Other differences in the standards and other factors that affect the lease related items, make comprehensive adjustment impossible. However, following our approaches above you can do enough to resolve much of the problem that arises from the difference between IFRS 16 and the equivalent US GAAP requirements and hence make meaningful global comparisons.

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