On January 1st, 2019, lease accounting is changing (at last!). Leases longer than one year will be put on a company’s balance sheet in a similar way to finance or capital leases.

We expected US GAAP and IFRS would take a consistent approach (they were discussing lease accounting approaches for years), but unfortunately, they have not. Here is a summary of the changes:

IFRS 16

All leases beyond 1 year are accounted for as finance or capital leases. Leases under 1 year are expensed. Also, very small leases <$5k will be expensed. That’s about it for the changes under IFRS – essentially operating leases are gone.

US GAAP ASU 842

US GAAP still has a distinction between finance/capital leases and operating leases. Both capital and operating leases are on the balance sheet, but the income statement impact is different.

Like IFRS, under US GAAP leases under 1 year are expensed, as are small leases (however, US GAAP has a materiality test rather than a $ amount).

The tests for finance leases are the same as before.

Leases which don’t meet the finance lease tests are treated as operating leases, and this is where it’s important to understand the changes. US GAAP creates both an asset and a liability on the balance sheet for operating leases.

Oddly, US GAAP continues to expense cash operating lease costs on the income statement, and no interest or depreciation is expensed. So how does the balance sheet balance??

Assume the lease goes onto the balance sheet as a 90m asset and a 90m liability.

The liability is treated normally – accrue interest at say 5%: 90 x 5% = 4.5, then subtract the cash lease payment of 33, so the ending balance is: 90 + 4.5 – 33 = 61.5

The asset initially goes onto the balance sheet at 90. However, then you need to suspend reality a little, as the ‘depreciation’ is a plug to make the asset the same as the liability. So, the depreciation = 33 – 4.5 = 28.5.

Even more crazy the income statement ignores the interest and depreciation and just expenses the rent paid as part of SG&A and COGS.

Valuation adjustments

So, for trading comparables, you STILL need to adjust earnings (i.e. add back operating lease rent expense to EBITDA) to put companies on a level playing field with other companies whether they report under US GAAP (as their mix of leases might be different) or IFRS.

Enrol in the online course Lease Accounting Update for 2019 to learn more