Leasing and leverage – credit rating agencies disagree

Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.


A reader of The Footnotes Analyst recently told us that there is still confusion in the equity market about how to deal with the new IFRS 16 lease accounting in analysis and valuation. Some equity investors and analysts are working with the new numbers while others seem to be reversing out the recent changes to work on the old accounting basis.

This confusion also seems to be mirrored in the debt markets. The rating agency Fitch has recently released an exposure draft of their proposed approach to measuring key analytical metrics post IFRS 16 and US GAAP ASC 842, but it is significantly different from that of Moody’s and Standard and Poor’s (S&P).

The need for global comparability presents challenges for the rating agencies

As rating agencies have a global perspective, they need to find a single approach and single set of metrics. Unfortunately, despite recent accounting standards convergence, the new lease accounting rules under IFRS and US GAAP are significantly different, particularly with regard to the presentation of profit and cash flow metrics used by investors.

While the initial recognition of a lease liability and associated right-of-use asset are the same under IFRS and US GAAP, the subsequent accounting differs. Under IFRS all leases are treated as financing, and the accounting for the right-of-use asset and lease liability are the same as for any other fixed asset and debt finance. This produces the depreciation and interest expense presentation in profit and loss. However, under US GAAP the old distinction between finance (capital) leases and operating leases remains, with operating leases having an operating expense equal to the lease payment, rather than separate depreciation and interest. Although the US GAAP lease liability is on-balance sheet and measured in almost the same way as under IFRS, in effect, it is not regarded as debt but as a form of operating liability. This also affects cash flow, with lease payments regarded as an operating outflow under US GAAP but a financing outflow (debt repayment) under IFRS.

For more explanation of the difference between IFRS 16 and US GAAP ASC 842 and for an interactive model illustrating the different outcomes – see our article Operating leases: You may still need to adjust.

Below we explain the rating agency approaches to dealing with the accounting difference, the other adjustments they make and our view on each of them. We only cover their policies regarding IFRS and US GAAP reporters. All of the rating agencies also adjust other reporting regimes to achieve approximately the same outcome.

Rating agency approaches to lease accounting

(1) Operating profit and expense classification

To achieve global comparability of profit metrics the rating agencies essentially need to pick either the IFRS financing approach or the US GAAP operating approach as their benchmark for operating leases. Fitch favours US GAAP whereas Moody’s and S&P favour IFRS.

FitchThe income statement of IFRS reporters is restated using the US GAAP approach, with depreciation and interest expense combined as a single operating expense. For US GAAP reporters all leases are treated as operating leases which means that finance (capital) leases are also adjusted.
Moody’s and S&PUS GAAP data is adjusted to approximate IFRS, with the operating lease expenses reclassified as depreciation and interest. Interest equals the outstanding lease liability multiplied by the disclosed average discount rate for the lease portfolio. Depreciation is then the balancing figure.

We think that lease obligations are economically no different from other forms of debt finance. Our recommendation is to adopt the IFRS 16 approach and consistently treat lease obligations as debt for all aspects of financial analysis. This means adjusting the income statement of US GAAP reporters in a manner similar to that suggested by Moody’s and S&P.

However, the rating agency adjustments are simplified and do not necessarily achieve full comparability due to the inherent assumption that the lease portfolio is in steady state, with an average maturity of 50% of the lease life. The front-loading effect of lease capitalisation means that, for immature portfolios, the single operating lease expense is lower than the sum of depreciation and interest. The opposite is true for lease portfolios where, on average, leases are more mature. Only by allowing for lease maturity would metrics be truly comparable.

For more about how the operating lease expense can differ from the sum of depreciation and interest see our article Leasing – Are you prepared for IFRS 16?

Click here for an illustration of how lease accounting differs under IFRS and US GAAP

We used this model in our article about the differences between IFRS and US GAAP lease accounting. For a detailed explanation about what it demonstrates see: Interactive model: Convert US lease accounting to IFRS

This is an interactive model – the blue input cells can be changed

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(2) Classification of lease liabilities and the effect on financial leverage

Moody’s and S&P follow IFRS and regard lease liabilities as debt whereas Fitch seems to have a very different view of the nature and relevance of a lease liability.

FitchFor most sectors Fitch does not regard lease obligations as debt. In effect, it follows the US GAAP approach and treats the obligation as a form of operating liability on the basis that a lease / buy decision is primarily operating in nature. However, for “lease dependent sectors” Fitch does, where relevant, present certain metrics on a “lease adjusted” basis, taking into account the capitalised amount of lease liabilities. An exception to the operating liability view seems to be the transport sector, where Fitch says that lease liabilities are regarded as debt finance.
Moody’s and S&PAll lease liabilities are classified as part of debt.

Fitch appears to generally regard lease obligations and the lease expense as operating because they are concerned about the inconsistency between the accounting for leases that are capitalised and service contracts that are not. They think that leases and service contracts can be economically similar and that companies have a degree of choice as to whether to structure an arrangement as a lease or a service contract. Treating all leases as service contracts supposedly resolves this issue.

We do not agree with this approach. We think that leases are different because they transfer control of an asset to a lessee. Service contracts are an example of an executory contract which, while potentially creating fixed commitments, do not result in recognised assets and consequently there is no debt liability.1There is one situation where service contracts may be capitalised, which is where a lease includes a service component, such as a property lease where the payments include a service charge. Companies have the option of separating the service component and only capitalising the remaining lease payments or of treating the full payment as though it relates to the lease. The resulting lack of comparability is unfortunate and, if significant, is something you may need to consider when comparing financial leverage. In practice, comparing lease arrangements and service contracts can be a challenge because there is no specific required disclosure of the terms or even of the existence of service contracts. However, we do not believe the deficiencies in service contract disclosures (we would like to see more) warrants treating leases in the same way.

(3) Measuring the lease liability

The measurement of the lease liability under IFRS and US GAAP is very similar, which means there is little need for adjustment to achieve global comparability. There are differences in the scope of what is capitalised, with IFRS 16 offering the optional ‘small asset’ exemption which is not available under US GAAP, and a difference in the treatment of leases linked to an index. However, for most companies the effects are unlikely to be material. Despite this the rating agencies approaches are quite different.

FitchOnly for the transport sector does it seem that Fitch uses the accounting liability. For other sectors that are “lease dependent” they calculate their own measure based on a multiple of the annual lease payments. This is the same approach they used prior to the new standards. Capitalisation multiples are sector specific and reflect “standard asset lives and discount rate assumptions”. Fitch adopts the same approach for both IFRS and US GAAP reporters.
Moody’sNo adjustment is made to the amount reported in the balance sheet under IFRS or US GAAP. However, a “qualitative overlay” is applied in respect of short-term and long-term leases. Moody’s regards some short-term leases as potentially more onerous than would be suggested by the balance sheet liability, due to the likely need to replace the asset. Long-term leases are potentially less onerous due to the flexibility to renegotiate if necessary. The liability itself is not adjusted, but these additional factors are taken into account in the interpretation of the resulting metrics.
S&PThe balance sheet liability measured under IFRS or US GAAP is used, except where S&P judges that a company uses “artificially short leases”. In this case the lease debt is adjusted to better reflect lease leverage. They suggest that, in most cases, the reported lease liabilities should be at least three times the next 12 months’ lease commitments and that the debt amount be adjusted to reflect this.

We do not agree with the Fitch approach or with the 3-year minimum liability applied by S&P. In our view, the accounting liability should generally be used without adjustment.

However, we think that an adjustment is warranted for leases with payments linked to inflation. Under both IFRS and US GAAP the lease liability fails to reflect the inflation link and may be significantly understated. For more on this issue see our article Beware the IFRS 16 inflation headwind.

Fitch prefers to use standard lease capitalisation factors because it considers that the accounting liability is not comparable as different companies may use different length leases for the same underlying asset. We think that variations in lease term reflect economic differences that should be captured in any analysis.  

Leasing analysis should go beyond financial leverage

In our view merely analysing financial leverage is not enough and the impact of leasing on operating leverage and business flexibility is relevant, which we assume is the reason for the “qualitative overlay” specified by Moody’s. The S&P adjustment to increase lease debt where lease terms are less than 3 years may be, in part, motivated by a desire to reflect other risks in financial leverage metrics. We think that it is best not to make such an adjustment but to evaluate other risk factors separately.

(4) Cash flow measures

With US GAAP presenting lease cash flows as operating but IFRS classifying in the same manner as debt cash flows, adjustments are inevitably required to achieve global comparability. But, once again, the 3 rating agencies end up with 3 very different approaches.

Fitch All lease payments are classified as operating cash flows. For US GAAP reporters this means no adjustment in respect of operating leases. However, for US GAAP finance leases and all capitalised leases for IFRS reporters, those cash flows presented as financing are reclassified as operating. Remember that IFRS permits the interest component of lease cash flows to be classified as either operating or financing, so an adjustment for this item is only required if it is not already classified as financing.   
Moody’sFor IFRS reporters the principal component of lease payments is reclassified from financing to capital expenditure. The interest component, if reported as a financing cash flow, is reclassified to operating cash flow. For US GAAP reporters, that part of the operating cash flow, which is equivalent to the depreciation reported in the income statement, is reclassified to capital expenditure.
S&PAll lease payments are regarded as financing cash flows. This means that, for US GAAP reporters, operating lease payments are reclassified out of the operating category to financing, thereby removing the operating and finance lease distinction. For IFRS reporters the principal element of lease payments is already in financing but, if the interest component of lease payments is included in operating, this is also reclassified. S&P emphasise that they make no adjustment for ‘implied capital expenditure’ – see our view below.

We think that lease payments represent the payment of interest and the repayment of the principal of debt; therefore, they should be a financing cash flow. This includes the interest component because we think operating cash flow is best thought of as the cash equivalent of operating profit. However, we also believe that entering into a lease agreement is akin to the purchase of fixed assets and that the strict focus on only pure cash flows can be misleading.

As S&P suggests (although they make no adjustment) there is an implied capital expenditure outflow when new leases originate, offset by an implied lease debt inflow. We believe that adjustment for these effective flows enhances the relevance of cash flow metrics. To learn more, see our article When cash flows should include non-cash flows.

Operating leverage and business flexibility

Financial leverage arising from lease liabilities is only part of the analysis needed to understand financial position, performance and risk; you also need to consider the impact on operating leverage and business flexibility.

Operating leverage is the additional risk arising from a business’s cost structure. Higher operating leverage results from higher fixed costs relative to variable costs and is further magnified where operating margins are low. It is commonly defined as the relative variability of operating profit compared with revenue. For example, if a 10% change in revenue produces a 30% change in operating profit then the degree of operating leverage is 3x.

However, operating leverage is complicated by the fact that fixed costs have a time dimension; what might be fixed in the short-term could be managed and, in effect, variable over a longer period. While in the above example profit may temporarily fall by 30%, the more there is flexibility to manage those fixed costs the sooner can that leverage effect be mitigated. Operating leverage can be thought of as a combination of the cost structure and the flexibility to change that cost structure. We think it can also help if you consider these two effects separately.

  • Operating leverage: The added risk due to fixed operating costs. High operating leverage arises from high fixed costs and results in higher variations in operating profit for a given variation in revenue. The degree of operating leverage (DOL) is given by:

{ \sf {DOL \,= \,\dfrac {\%\, Change \,in \,Operating \,Profit} {\%\, Change \,in \,Revenue}\,\, = \,\, \dfrac {Revenue \,-\, Variable \,Costs} {Operating \,Profit} }}

  • Business flexibility:  The ability to change the cost structure and manage fixed costs. High business flexibility means that a company can more rapidly react to changes in business dynamics, such as a change in customer demand.

Business flexibility interacts with operating leverage to determine how business risks impact profit – a company that has more flexibility may be able to minimise the leverage effects of fixed costs.

Impact of leasing on operating leverage and business flexibility

Depreciation arising from capitalised leases is likely to be a fixed cost. The period it is fixed for, and therefore the impact of any operating leverage effect, depends on business flexibility, which in turn is affected by the length and terms of the leases utilised.

The depreciation expense arising from short-term leases is relatively higher than that for long-term leases. For example, a 1-year lease might have an average depreciation expense equal to 95% of the lease payment, with interest being just 5%. However, the same asset leased for 10 years may have just 70% depreciation and 30% interest (the exact numbers depend on the discount rate). The result is higher operating leverage for the shorter-term lease, although the impact of this will often be more than offset by the fact that shorter term leases are more flexible, given the ability to simply not renew.

Short-term leases may not always result in greater business flexibility

However, this may not always be true. If the leased asset is essential to the business, irrespective of changes in the level of demand, such as it forms part of a head office function, then it may not be an option to simply stop using the asset when the short-term lease expires. In effect, renewal of the lease is a necessity. In this case the lack of business flexibility means that there is no mitigation of the operating leverage effect of the higher fixed depreciation expense arising from a shorter-term lease.

It is not just the term of leases that impacts flexibility; cancellation and renewal options can add flexibility to long term leases. In addition, lease payments that vary with revenue and activity also reduce risk by turning what is normally a fixed expense into one that varies either partially or fully in line with changes in revenue. This is also recognised in the accounting since leases with variable lease payments of this nature are not subject to capitalisation in the first place; instead the expense is recognised as incurred.

The approach of the rating agencies

Although the rating agencies do not directly address operating leverage and business flexibility in their leasing guidance, some of their adjustments might be motivated by these factors.

The S&P adjustment to lease debt in order to ensure that the liability reflects a minimum of 3 years of lease payments is perhaps a way of capturing this higher operating leverage within the metrics that describe financial leverage. However, the 3-year minimum seems to be somewhat arbitrary, as is the underlying assumption that the business lacks the flexibility to take advantage of the shorter lease terms.

By using standardised lease capitalisation factors Fitch also seems to mix financial leverage, operating leverage and business flexibility in their approach to lease capitalisation. For companies with predominantly short-term leases the Fitch approach would presumably lead to a higher liability than that used by Moody’s or S&P. This may be justified on the grounds of higher operating leverage, but it may not be, considering business flexibility.

Because business flexibility and the impact of operating leverage is highly sector and company specific, we prefer the approach of Moody’s where financial leverage simply reflects committed lease payments, and that this is combined with a separate “qualitative overlay”.

Insights for Investors

  • The economics of leasing is very similar to that of purchasing an asset financed by debt. Evaluate leasing as debt finance and fixed assets for all aspects of your analysis and valuation.
  • If you need global comparability, adjust US GAAP reporters to be consistent with IFRS.
  • Use the reported lease liability without adjustment. Generally, only for inflation linked leases would the balance sheet figure not fairly reflect financial leverage.
  • Short-term leases result in lower financial leverage but could result in higher operating leverage. Evaluate operating leverage together with business flexibilityshort lease terms, options to cancel and variable lease payments all enhance flexibility.
  • Remember that the initial recognition of a lease creates an effective capital expenditure flow that should be reflected in enterprise free cash flow.
  • Don’t forget that service contracts can also create commitments that impact business risks.

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