Lease Accounting: Operating Leases, Finance Leases, and the Confusing, Changing Rules

[@financialmodeling]

For the files and resources, please see: www.mergersandinquisitions.com/lease-accounting/ No, not every single example is available there, but most of them are. It's a complicated and confusing topic, so we are sharing the most useful bits.

[@nocancelcultureaccepted9316]

Thank you!

[@ankurdhawan132]

Thank you so much brother for explaining this topic with example, I was really struggling with this topic but your video really simplified the whole process.

[@financialmodeling]

Thanks for watching!

[@raptokvortex]

Just covered this in my accounting exam

[@qwobify]

Germans are notorious for technical interview questions. Had a German PE partner interview me today (I’m based in London) and the first question he asked me was to state the journal entries when creating a deferred tax liability…

[@tedgrove9412]

How did the interview go?

[@financialmodeling]

Yup, agreed. Seems like a tough place to interview/work...

[@StheSharknl]

Ze Germans are notorious with the technicals

[@thebluesquid8471]

bro, best video on asc842 and ifrs16...helped me a ton

[@financialmodeling]

Thanks for watching!

[@njabulov.hadebe9102]

i love these videos so much. i wish youtube can pay you as much as you want for these videos. pure class and excellence! keep going BIWS this is a confusing topic, how would one get to know what the lease details are for a company in the notes to the financial statements?

[@financialmodeling]

Thanks! It's impossible to get all the lease details just from a company's financial statements. This is why you tend to project lease line items at a high level and avoid obsessing over the details. Cash flow is king... so focus on the cash the company pays for leases each year.

[@njabulov.hadebe9102]

@@financialmodeling By Cash do you mean that the lease payments in the I/S should be equal to the finance lease repayments? its much simpler if it were like that. but the interest portion needs to also go in the I/S as a finance cost, what do we do then?

[@financialmodeling]

@@njabulov.hadebe9102 Lease Interest + Lease Depreciation ~= Lease Interest + Lease Principal Repayments for a large lease portfolio. Use the other side of the equation if the company doesn't disclose Lease Depreciation.

[@DreamFirms]

Had a great time watching your video!

[@financialmodeling]

Thanks for watching!

[@StheSharknl]

Thank you for the video Brian, it’s clear! Appreciate the attention to IFRS treatment ;)

[@financialmodeling]

Thanks for watching!

[@sebperez93]

To calculate unlevered free cash flow, in the case of capital leases (and all IFRS), don’t you need to: a) subtract the lease liab interest expense portion from EBIT B) subtract the lease liab principal repayment portion Where A+B = the actual cash outflow related to the lease (ie the rent) And then C) add back all lease asset depreciation because this is non cash and not adding it back would in some Way be double counting the expense from the lease

[@financialmodeling]

You could take that approach, but for a large portfolio of leases, Lease Interest + Lease Depreciation ~= Lease Interest + Lease Principal Repayments, so it's easier to stick to the IS line items and just exclude the Lease D&A in the add-backs.

[@danielcheong7179]

@@financialmodeling Wow thanks so much man

[@maskedcat8808]

Great video thanks Brian! A follow up question: to calculate levered FCF under US GAAP a quick way would be to take cash flow from operations and minus capex. Under IFRS with leases, would the equivalent be cashflow from operations - capex - lease repayment (under cash flow from investing activities)?

[@financialmodeling]

Yes, that method would work under IFRS, but it actually calculates Free Cash Flow, not Levered Free Cash Flow. Another approach is to still use Cash Flow from Operations minus CapEx, but *exclude* Lease Depreciation from the Total Depreciation figure added back within CFO so that FCF figure deducts Lease Interest and Lease Depreciation, which should roughly equal the Lease Interest + Lease Principal Repayment, AKA the total cash lease expense.

[@Cool-yh5cz]

Hi - Thank you for the in depth review. I am london based hence work mostly with IFRS/pre IFRS. My question is based around Football field and valuation using DCF vs LBO (using pre IFRS guidelines). Under the LBO, we would mostly deduct the leases principal in the CF statement every year and the interest in the NI which will get a tax-saving effect. When doing a DCf, we would adjust for the leases in the EV but will not account for the tax-saving effect. Should we adjust this in the LBO cash flow statment? I might have misunderstood so please let me know if this is not the correct way to approach this question.

[@financialmodeling]

If you want to factor in the taxes, just deduct both the lease interest and lease depreciation and then do *not* add back the lease depreciation. And then you don't have to worry about subtracting the lease principal repayments. This method applies to both LBO and DCF models. On balance, it's easier to simply use the Total Depreciation as stated and then subtract the Lease Principal Repayments because you don't have to worry about Lease vs. Non-Lease Depreciation, but it is less accurate in terms of the tax savings.

[@ngmingchiat7469]

For the cash flow statement of (Additions Lease Assets) and (Additions to Lease Liabilities), could you briefly tell me, or just show a screenshot of how the answer suppose to be (for IFRS)? and Thank you for your helpful video.

[@financialmodeling]

The additions to Lease Assets and Lease Liabilities should be roughly the same each year under both accounting systems. There are reasons why that might not happen exactly, but for modeling/projection purposes, leasing a new asset doesn't affect a company's cash flow in the near-term other than the additional rental expense associated with it and possible other/smaller initiation fees.

[@sadsasadsaf4807]

If I am doing a comp set that includes companies using IFRS and US GAAP... should i treat operating leases as debt for consistency? and then try to find the rental expense for those US GAAP companies (to effectively calculate EV/EBITDAR)?

[@financialmodeling]

Yes, that is the easiest solution. Most companies do disclose their total rental expense in the annual filings.

[@KrishanSingh-gz9op]

Question 1 :- why are we applying discount rate on leases? Question 2:- Can I calculate interest cost on leases , by taking interest paid on leases and dividing it by total lease liabilities?

[@financialmodeling]

Leases are recorded at their Present Value on the Balance Sheet, so the discount rate is required. It's much easier simply to look up the company's own discount rate it uses in its filings to estimate the cost of leases.

[@j8306]

Not sure if I miss anything, but for the first part (2:32) the Lease Asset and Lease Liability under finance lease and IFRS operating lease seemed to be reduced at different rate each year Lease Asset reduced by depre while Lease Liab reduced by Principal repayment) But under GAAP both are decliend in the same rate as Depre=principal repayment. But under file at 19:38 in Balance sheet, Why under IFRS16, ROU asset=Operating Lease while it is unequal under GAAP (ROU asset=225 while Operating lease=210) where does 225 and 210 comes from? Thank you

[@financialmodeling]

Yes, the lease asset and liability may change at different rates under IFRS vs. U.S. GAAP. This is just how it works for a single lease. Over a huge portfolio of leases, these differences diminish. The 210 vs. 225 are arbitrary and don't correspond to any specific rule. Sometimes the Lease Assets and Liabilities do not equal each other exactly, and sometimes they do or are closer. But what really matters for all these calculations is the Lease Liability number, which is the same for both.

[@Retumn98716]

great video. is most of this informatoin still up to date (I am europe based) ?

[@financialmodeling]

Lease accounting has not changed since IFRS 16 went into effect in 2019.

[@Habib-fz3zq]

I am putting together a document as part of a project to explain the difference between CAPEX and OP lease expenditure. Your video is great. One thing that's not clear to me (not from your video but generally speaking) is how is the cost of refurbishing/improving the lease treated under IFRS, if anyone has a link or info on that. Many thanks for your videos. I hope to see more of them.

[@financialmodeling]

Not sure offhand, but I would assume it's capitalized and then treated the same as the rest of the lease, with the interest and depreciation modified accordingly.

[@Habib-fz3zq]

@@financialmodeling thank you for taking the time to reply

[@Ivan-hl1oy]

I have one question, In DCF valuation (Under IFRS16), If we shouldn't add back all depreciation for calculating Unlevered FCF, what about EBIT? We deduct all depreciation include leases portion from Gross profit in Operating Expense ?

[@financialmodeling]

Yes, you need to adjust EBIT by deducting the Interest Element of the Lease Expense (from all lease types is easiest) under IFRS when calculating UFCF.

[@Ivan-hl1oy]

@@financialmodeling Thanks, but I don't clearly understand one thing.If we deduct all Leases and don't count Leases in Enterprise Value, What about Invested Capital ? If we don't include Lease Liabilities in Invested Capital, we get very increased ROIC, especially for companies with large Leases portfolio ?

[@financialmodeling]

@@Ivan-hl1oy If you don't count leases in invested capital, then you deduct the lease expense in the numerator (NOPAT) instead. So ROIC should be about the same because in one case, the numerator is smaller and the denominator is also smaller, and in the other case, both the numerator and denominator are larger.

[@dbsk06]

13:24 still only rental income but split into interest vs depreciation off the statements

[@lykken007]

Thank you for this. Is there a way that you could post the TGT model for review?

[@financialmodeling]

The available Excel files are posted here and in the other videos/articles on lease accounting and IFRS 16.

[@pmr5336]

Is there an argument to be made, treating leases like CapEx but also deducting it from firm value? If I understand it right we have one leases as a debt-like item in the form of the repayment and interest payment and second the CapEx part of taking on new leases to fill in for the ones that expired. This would mean adding back the full depreciation on leases, decucting the lease repayment charge as a proxy for taking on new leases in CapEx and finally the deduction of the lease liability from the firm value. In the other treatments my value always goes through the roof, which seems to be the lack of taking into account future leases.

[@financialmodeling]

The longer answer is it's complicated, but the short answer is if you want to count leases as capital, you need to include them in WACC, exclude the full lease expense in UFCF, but deduct a term for the Change in the PV of Lease Payments each year to account for the company signing and replacing new leases over time. Ignore lease depreciation and principal repayments and so on and focus on those. See Damodaran's paper on it.

[@maisamsna]

For calculating the lease interest expenses, did you assume that the discount rate (WACC) equals the interest rate? Because interest expenses= interest rate X outstanding liability

[@financialmodeling]

You use the lease discount rate the company estimates in its filings. This discount rate is not WACC but tends to be closer to the Cost of Debt since leases are, effectively, another form of Debt when you treat them like this.

[@kevinblack6721]

How can the ROU asset and liability not balance? What am I missing here?

[@financialmodeling]

They don't necessarily equal each other because of different start and end dates for leases and the way items like termination fees, sign-up fees, and other fees outside of lease payments are recorded.

[@kaixu7454]

Maybe I’m confusing myself here, but are you saying you don’t include leases in your implied enterprise value in DCF?

[@financialmodeling]

If you've deducted the *full* lease expense in the UFCF projections, then you do not subtract lease liabilities when moving from Implied Enterprise Value to Implied Equity Value in the bridge.

[@swetapatra]

hi thank you for this. but what do we do when right to use asset is not equal to the lease liability. for ex in this case - 154 is ROU but say lease liability is only 50 instead of 154. and the rest of the asset is prepaid out of pocket. how to account in such case

[@financialmodeling]

Cannot answer this question without knowing the accounting system you're using. If it's U.S. GAAP, just keep growing both the lease asset and lease liability at the same percentages, in-line with rent. Under IFRS, it's a bit more complicated because you need assumptions for the lease interest/depreciation/principal repayment, but the same thing should generally happen: both keep growing at a modest rate, in-line with the amount the company is spending on annual rent.

[@mengjieni317]

Question - is the IFRS16 apply to Australia : )

[@financialmodeling]

Yes

[@vincentnguyen6833]

Great video Brian, just a question on treating operating and finance lease in DCF under U.S. GAAP and IFRS. If accounting for leases in unlevered FCF and not deducting operating/finance lease from TEV , under IFRS for both operating and finance leases, we would need to deduct D&A of ROU asset (operating expense) and interest component of both operating and finance leases (non-operating expense) as rental expense roughly equals D&A of ROU asset + Interest component. And under U.S. GAAP, finance leases are treated the same way, but for operating leases, rental expense is already deducted in operating expenses? Thanks

[@financialmodeling]

Thanks. Yes, if you do not deduct either lease liability in the bridge, then you need to deduct the *entire* lease expense - both depreciation and interest - in UFCF and *not* add back the lease depreciation. So it requires some adjustments under IFRS. It's easier to do it this way under U.S. GAAP because the rental expense is already within OpEx, so it should be deducted anyway, and many companies do not even have Finance Leases. If they do, they're usually very small, so sometimes people just ignore the finance lease interest element (or the company may not even disclose it separately).

[@vincentnguyen6833]

@@financialmodeling Thanks for the response. If I decided on the alternative method of subtracting the lease liability from implied EV and not deduct rent from UFCF, would I need to account for the weight / cost of the lease in WACC or would it be combined with COD? Cheers

[@financialmodeling]

@@vincentnguyen6833 Yes, you would include them in WACC in that case. You could potentially combine all leases with Debt, but it would be better to treat them separately. Take a look at the latest video in this channel on the WACC formula for an example.

[@financialmodeling]

@@vincentnguyen6833 Please see the most recent video in this channel on WACC.