Financial statement users have long been aware of the hidden leverage that arises from lease obligations, especially in the retail industry. As companies file their first financial results for 2019, financial statement preparers and users alike will finally find these leases brought to light, thanks to the new lease accounting standards issued by FASB and IASB.
But while the new standards add clarity, they also present new comparability challenges and nuances between IFRS and U.S. GAAP treatment. CFA Institute created a guide to help investors decipher the changes.
Finance executives should explore many of the same issues that investors need to understand, as everyone is experiencing the standards for the first time. Here we’ll call attention to those key considerations.
Balance Sheets Get Larger
IFRS and U.S. GAAP share the view that an obligation to make lease payments is a liability that should be recognized on the balance sheet. That’s regardless of whether the lease is classified as an operating lease or a finance lease.
The liability is measured as the present value of future lease payments, and this liability’s offset is a “right-of-use” asset. The latter represents the lessee’s right to use the lessor’s asset over the lease term; therefore all leases will now create both an asset and a liability for the lessee.
The increase in total assets and debt will have a significant impact on key ratios. Return on assets will decline and, as highlighted in the chart below, solvency ratios such as financial leverage ratio and debt-to-equity will rise substantially. Given that a portion of the lease liability will be included in current liabilities, liquidity ratios will decline.
Challenges in Income Statement Comparability
Income statement comparability becomes more challenging due to FASB’s and IASB’s decision to go different ways in the classification of leasing arrangements.
U.S. GAAP states that many leases will be classified as “operating leases,” and there will be little change to the income statement and cash flow statement. Under IFRS, as well as some leases under U.S. GAAP, all leases will be classified as “finance leases” and overall expense recognition will be higher in the earlier years of the lease.
The graph below highlights the operating lease (U.S. GAAP) versus finance lease (IFRS) pattern of expense recognition.
This change in presentation on the income statement for finance leases will also impact profitability ratios, as defined in the chart below. The fact that higher expense is recognized in earlier years for finance leases means net income and earnings per share will be lower for finance leases (IFRS companies) than operating leases (U.S. GAAP companies) during these years.
What many don’t realize is that gross profit and operating margin will rise because a portion of the prior lease expense is now reclassified to finance cost.
Overall, IFRS companies will have lower net income but higher operating income than U.S. GAAP companies. Investors must remember to adjust for these differences in comparing U.S. GAAP to IFRS companies. Finance executives must remember that global competitors will be impacted differently by the standards.
Presentation of Cash Flows Changes, Actual Cash Flows Don’t
Cash flows are not changing, but their presentation will change for IFRS companies and U.S. GAAP companies with finance leases.
Under IFRS, cash flows from operations and financing cash outflows will increase. That’s also the case when there is a finance lease for U.S. GAAP.
Why? If a lease is a finance lease, the portion of the lease payment representing a repayment of the lease liability will be classified as a financing cash outflow rather than an operating cash outflow.
On the other hand, under U.S. GAAP, cash flows from operations will remain unchanged from prior periods for operating leases. Once again comparability is a casualty of the new standards. Performance and coverage ratios will look better for IFRS companies than for U.S. GAAP companies as they utilize cash flow from operations.
Mind the Non-GAAP Measures
Compounding the IFRS and U.S. GAAP difference is that the recognition of interest expense for finance leases can create differences in non-GAAP measures, such as EBIT and EBITDA.
EBIT and EBITDA will be higher for companies with finance leases and companies that report under IFRS where all leases are classified as finance leases. That’s because interest expense and amortization expense are presented “below the line” of operating profit.
These non-GAAP measures will not change for operating leases (U.S. GAAP). EBITDAR (earnings before interest taxes depreciation amortization and rent) is the only way to make a like-for-like comparison between IFRS and U.S. GAAP companies.
While U.S. GAAP companies perceive the U.S. GAAP standard as better because it creates a level expense, IFRS companies will benefit from higher non-GAAP measures heavily relied upon by investors. Investors should be mindful of the creation of new non-GAAP measures to explain these differences.
Comparability Gets Even More Challenging
While restatement of prior periods is permitted under both U.S. GAAP and IFRS, the restatement methods are not identical, and most companies have elected an easier transition approach whereby prior periods are not restated; instead, the new accounting is applied to all leases in effect as of January 1, 2019.
For many companies, assets and liabilities of companies will not be comparable relative to their prior periods; and trend analysis for many common profitability measures and financial statement ratios will be distorted.
The new leasing standard dramatically impacts key ratios, not only because of the type of lease (operating vs. financing) but also due to the method of transition to the new standard.
Impacts to solvency and profitability ratios previously highlighted are not the only changes. Changes in return on equity, return on assets, and coverage ratios will also be impacted. Investors and finance officers will want to isolate and understand these impacts, as there will be many.
Lease Disclosure Are More Important Than Ever
Historically, investors relied solely on the lease footnote to determine a company’s lease leverage. Now on the balance sheet, some might perceive the footnote is less important than it used to be. The opposite is true.
The lease footnote is something investors will want to examine closely for several reasons: First, to compare the lease liability recognized at transition to the prior lease commitments disclosed. Second, to understand the estimates and assumptions used in arriving at the lease liability including the weighted average discount rate, weighted average lease term, treatment of lease renewals, variable lease payments, short-term leases, and cash paid for leases, to name just a few.
U.S. GAAP and IFRS have different disclosure requirements, some better for IFRS (variable payments) and others better for U.S. GAAP (weighted average discount rate).
Because both U.S. GAAP and IFRS have a “set-it-and-forget-it” approach to the measurement of the lease liability, the liability recognized at transition is not updated significantly over the lease term to reflect current market conditions.
Accordingly, investors seeking a liability measurement that reflects the current value of the leasing arrangement will be disappointed and will need to use the disclosures provided to make estimates of the current value of the leases.
Financial executives should know that investors will turn to disclosures to help them understand the analytical challenges brought on by the new standard.
Sandy Peters is head of financial reporting policy CFA Institute and serves as the organization’s spokesperson on key financial reporting standard setters including FASB, the IASB, FASB, and the U.S. Securities and Exchange Commission.