Sale and leaseback: Operating risks and reporting anomalies

It is important to consider the impact of different leasing structures on operational risk, in addition to financial leverage. Leases with variable payments reduce operating risk, but sale and leaseback transactions may have the opposite effect. We use hotel company International Hotels Group and airline EasyJet to illustrate.

IFRS accounting for leases with variable payments and for sale and leaseback transactions is clear. However, combining the two in one transaction is more problematic. The IASB’s recently proposed amendment to IFRS 16 would bring leases with variable payments arising from sale and leaseback transactions onto the balance sheet. We explain why we disagree.


After two years of lease capitalisation under IFRS 16, most of you will be familiar with the implications for financial statements and the key metrics used in your analysis. Given the importance of leasing for many businesses and the scale of the accounting changes that have taken place, we have written a number of articles on the subject.

Selected Footnotes Analyst articles on lease accounting and related topics

Impact of IFRS 16 on financial statements and key metrics, including operating profit, net income, leverage and return on capital.

The difference between IFRS 16 and US GAAP, including how the US GAAP treatment of operating leases produces very different performance metrics.

How lease cash flows should be included in free cash flow metrics, including the concept of effective cash flows and lease capital expenditure.

Accounting for leases with variable payments linked to an inflation index and how the lease liability is understated under both IFRS and US GAAP.

Alternative methods of including lease liabilities in DCF models and the importance of consistency between cost of capital and free cash flow.

The effect of different leasing and ownership strategies for real-estate and the use of ‘Opco-Propco’ analysis to reveal value differences.

In this article we focus on two further aspects of IFRS 16 – variable lease payments and sale and leaseback transactions. These are important issues in their own right that impact reported metrics and both operating and financial risks. However, where the two features are combined in a single transaction – sale and lease back transactions where the leaseback involves variable lease payments – there is some confusion (and differences of opinion) in the world of accounting. The IASB has recently put forward proposals to ensure these transactions are accounted for in a consistent manner.

Leases with variable payments

There are two forms of variable lease payments – those that vary because they are tied to an external index or rate, such as consumer prices, and those that vary by reference to a company specific activity measure, such as revenue. It is the latter to which we refer here.1Leases where payments vary based on an index or rate are capitalised in the same way as for fixed leases. Initially the liability reflects the impact of the index at the inception of the lease. Subsequently the liability and right of use asset are adjusted if and when that index changes.

If lease payments vary based on revenue, profit or some other measure of activity then IFRS 16 requires that these leases are not capitalised and not reported as lease liabilities or right-of-use assets in the balance sheet. Instead, the lease payments are reported as an expense in the period they fall due, and the amount is disclosed in the footnotes.

Assets controlled by a company are omitted from the balance sheet

The decision to not capitalise leases with variable payments was a controversial one. The result is that assets controlled by a company are omitted from the balance sheet. This is at odds with the common approach in IFRS where ‘control’ determines the recognition of assets.  The main reason for non-recognition under IFRS 16 is one of cost-benefit – the cost and difficulty of forecasting the lease payments and keeping these forecasts up to date.

Some also argue that leases with variable payments are not a liability in the first place because the obligation to pay only arises if and when the trigger for payment is met, such as earning a certain amount of revenue. The counter argument to this is that the liability can be regarded as the obligation to ‘stand ready’ to pay, and that the uncertainty is one of measurement and not the existence of the obligation, or of the related asset. But whatever the reason, IFRS 16 is clear: no capitalisation.

One of the accounting challenges is to differentiate between fixed and variable lease payments. How variable do lease payments need to be to result in no capitalisation and can a company avoid capitalisation by introducing variability that has little economic impact? IFRS 16 addresses this by introducing the concept of ‘in-substance fixed’2In-substance fixed lease payments are payments that may seem to contain variability, but which are in-substance unavoidable. This may be because the variability is not genuine or is subject to an event that has no possibility of occurring. but the issue remains difficult and the meaning of ‘in-substance fixed’ is the subject of debate.

Impact on operating and financial risks

Not capitalising leases with variable payments produces lower reported debt and lower financial leverage in comparison with fixed leases. However, in some respects this may actually be a fairer reflection of the economics. Variable lease payments produce a risk transfer from lessee to lessor. The lessor has variable income that is subject to asset and business risks, whereas the lessee obtains a variable operating expense that would decline during times of stress, thereby reducing its own business and financial risk.3The risk reducing effects of variable lease payments are similar in some respects to the use of short-term leases, where it is easier to adjust to changes in business demand and other shocks. In our article Real estate and equity valuation: Opco-Propco analysis, we showed how, when leasing and ownership business models differ, analysis can be improved through an Opco–Propco separation. Of course, the lessee pays a price for this flexibility and risk reduction because variable lease payments would, on average, be expected to be higher than for an equivalent fixed lease.  

International Hotels Group is a good example of a business benefiting from the risk reducing effects of variable leases. Their variable lease payments fell dramatically during 2020, from $58m in 2019 to just $7m in 2020. Clearly this is due to Covid-19 related business disruption and reduced revenue and indicates that at least some of their Covid-19 related risks were shared with their lessors.

International Hotels Group – variable lease payments

Source: IHG financial statements 31 December 2020

There is no indication that the reduction was caused by fewer leases with variable payments. In fact, the opposite seems to be the case since, during 2020, the company reclassified some leases from being ‘in-substance fixed’ to variable. Presumably the variability clauses in these leases were previously not thought to have sufficient economic substance to be regarded as truly variable. The reclassification and the resulting derecognition of the right-of-use assets and lease liabilities produces a gain. In effect this gain arises due to the initial front-loading in lease accounting that produces a higher lease liability than a lease asset. Derecognising both the lease asset and lease liability of these fixed payment leases therefore produces a gain.4The front-loading effect of lease accounting refers to the tendency for the sum of the lease interest and right-of-use asset depreciation to be almost always greater than the cash lease payments in the early years of a lease and correspondingly lower in the latter years. The effect of this is that the lease liability tends to be higher than the lease asset through the full term of the lease. The scale of the front-loading effect depends on the depreciation method applied and the pattern of lease payments. For more explanation of the front-loading effect of lease accounting see our article Leasing: Are you prepared for IFRS 16?.   

International Hotels Group – in-substance fixed lease payments adjustment

Source: IHG financial statements 31 December 2020

Sale and leaseback transactions

A sale and leaseback transaction involves the sale of an asset currently owned by a company with simultaneous leaseback for a certain period.

You would think the accounting for a sale and leaseback should be relatively simple – just report an asset sale, with the gain or loss included in profit and loss, and then apply normal lease accounting to the lease and recognise a new right-of-use asset and lease liability. However, this would not fairly reflect the economics. In effect, a sale and leaseback is a combination of an asset sale and secured borrowing.

The existing owned asset can be thought of as two components, a right-of-use asset for the period of the proposed lease and the residual interest in the asset at the end of that lease term. In a sale and leaseback, it is only the residual interest that is in-substance sold. The lease right-of-use asset is simply a continuation of a component of the existing asset, for which new secured debt has been raised in the form of a lease liability. Any gain related to the ‘sale’ and repurchase of the right-of-use asset part is therefore unrealised and, under historical cost accounting, should not be recognised.

EasyJet raised £608m from sale and leaseback transactions in fiscal 2020

The sale and leaseback transactions by airline EasyJet during 2020 illustrate the accounting. The company sold 23 aircraft with a depreciated historical cost of £631m (comprising an original cost of £851m and accumulated depreciation at the date of sale of £220m). As a result of the sale, the asset carrying value is split into the amount that relates to the residual interest sold (£260m) and the amount which is attributable to the right-of-use asset retained (£371m).5The portion of the asset carrying amount that is attributed to the retained right-of-use asset is the present value of the lease payments (the new lease liability) divided by the fair value of the asset on the date of sale.

The total cash received from the transaction was £608m, but of this only £293m relates to the sale of the residual interest, which combined with the book value of the asset sold (£260m) produced a gain of £33m. The difference between the total cash received of £608m and the value of the residual interest sold of £293m is recognised as a new lease liability of £315m.

Summary of EasyJet 2020 sale and leaseback transactions

Source: EasyJet 30 September 2020 financial statements and The Footnotes Analyst estimates

EasyJet sale and leaseback transaction and fixed asset footnotes

Source: EasyJet 30 September 2020 financial statements. The above only reflects sale and leaseback transactions reported in their financial statements to 30 September 2020. Between that date and when the financial statements were published the company says a further 30 aircraft have been sold raising £717m.

You will notice that the new lease liability of £315m is lower than the recognised right-of-use asset of £371m. Normally we would expect the opposite, assuming that the sale was at the fair value of the asset. In this case it appears that the sale proceeds EasyJet received from the lessor was less than fair value; described by EasyJet as “below market terms”. Under IFRS 16 the difference between fair value (£371m) and sale proceeds (£315m) is regarded as, in effect, a part prepayment of the lease obligation. It seems that the aircraft lessors are taking a cautious position in not paying the full fair value for the aircraft but, to compensate, accept lower lease payments. A sale below fair value does not necessarily mean a bad deal. That depends on the lease payments and interest rate implicit in the lease, neither of which are specified separately for the sale and leaseback transactions in the case of EasyJet.

Impact on operating and financial risks

The risk impact of the EasyJet sale and leaseback transactions is a combination of: (1) a change in financial leverage, due to a change in reported debt; and (2) a change in operating leverage and operating flexibility due to a new operating cost structure and a more ‘asset-lite’ business model.

  • Financial leverage: For obvious reasons, Easyjet had a challenging year in 2020, and the sale and leaseback transactions were part of a wider effort to raise finance and preserve liquidity. The overall amount received from the sale and leaseback transactions of £608m would have resulted in less borrowing than otherwise would have been the case, but this has, in part, has been offset by the recognition of a new lease liability. Overall, the transaction has resulted in lower reported financial leverage than had the same finance been raised by issuing debt.
  • Operating leverage and flexibility: A leasing business model results in higher operating leverage and lower operating profit. This is because the depreciation of the new right-of-use assets would be higher than the equivalent amount for the same assets when owned outright. However, the higher operating leverage may be, in part, offset by the added flexibility of an asset-lite business model, where the residual asset risk is borne by the lessor.

The overall value effect of a sale and leaseback depends on how the market interprets the change in business model and the relative effect of the changes in financial leverage, operating leverage and profit. For more about lease versus purchase business models, their impact on value and the use of ‘Opco-Propco’ analysis, see our article Real-estate in equity valuation – Opco-Propco analysis. The article focused on real-estate, but it is equally applicable to strategic assets such as airplanes.

An accounting problem

The accounting for leases with variable payments and for sale and leaseback transactions are clearly specified in IFRS 16. However, if both features are present in a single transaction (in other words, the leaseback is a lease with variable payments), the accounting is not so clear, and it seems different approaches have been advocated and used in practice.

There is a contradiction in IFRS 16

This lack of guidance seems to have only became apparent after IFRS 16 was issued. Initially it was referred to the IFRS interpretations committee, but the IASB has now proposed to amend the standard to clarify the treatment of these transactions. The problem is that IFRS 16 says two contradictory things, both of which cannot be true.

  1. In a sale and leaseback, the carrying value of the new right-of-use asset is specified as a portion of the original carrying value. This to ensure that the gain on sale only applies to the residual interest sold.

  2. For a lease with variable payments there is no capitalisation, and so no right of use asset.

The IASB has proposed that the first requirement should trump the second. The consequence of this approach is that leases with variable payments that arise from sale and lease back transactions are capitalised and reported as a liability equal to the present value of the forecast variable lease payments. However, this introduces an inconsistency with other leases with variable payments which will continue to be off-balance sheet.  We do not think this is helpful for investors.

In addition, the IASB has proposed that, where a lease with variable payments is recognised as a liability, it should not be remeasured if the estimate of future variable lease payments changes. Any difference between the actual payment and the original expected amount would be reported as a ‘variable lease payment’ gain or loss. In our view this is confusing for investors and potentially could result in a very misleading liability. For example, if the variable payments have significantly reduced since the date of the sale and leaseback transaction, the reported lease liability would be higher than the actual economic obligation.

Our view

In our view all leases with variable lease payments should be accounted for in the same way, irrespective of how they came about.

Our preferred approach would be to account for leases with variable payments arising in a sale and leaseback transaction in the same manner as currently specified in IFRS 16 for other leases with variable payments. This accounting will result in the full difference between sale proceeds and carrying value being recognised in profit and loss. We do not think this is a problem and investors would be better served by recognising this full gain, and achieving consistency in accounting, than having the inconsistent treatment that would result from the IASB’s proposals.

Some will argue that recognising the full gain is incorrect when, in substance, not all of the asset has been sold. Deferring a portion of the gain could be used to avoid recognition of an ‘unrealised’ gain. However, we think the resulting deferred credit would not meet the definition of a liability under the IASB’s own Conceptual Framework and would not provide relevant information for investors. The resulting gain reported in subsequent periods would also not be relevant to the understanding of financial performance.

The IASB has just finished gathering responses to its proposals. We shall see in due course what their final approach will be. Our comment letter to the IASB, with further analysis and views on this difficult accounting issue, is shown below.

Insights for investors

  • Leases with variable payments that are linked to revenue, or another measure of performance or activity, reduce operating risks. These leases are not capitalised in financial statements.
  • Lack of recognition of right-of-use assets arising from leases with variable payments results in higher return on capital but this may not indicate higher added value.
  • Sale and leaseback transactions reduce reported financial leverage and result in a more ‘asset-lite’ business model. However, they also reduce operating profit and can result in higher operating leverage.
  • Don’t just evaluate companies based on reported profit and returns. Think about the consequence of different operating and financial risks.
  • Consider the use of Opco-Propco analysis when comparing companies with different asset ownership and leasing strategies.

The Footnotes Analyst letter on the IASB regarding the draft IFRS 16 amendment


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