Operating Leases as Debt
A company that rents its stores for 15 years has a fixed obligation much like a loan. Accounting rules now put most leases on the balance sheet for that reason.
Why this matters for beginners
Ignoring leases can make retailers, airlines and restaurants look far less indebted than they are. Learning objectives: read lease liabilities, understand the EBITDA effect, and calculate lease-adjusted leverage.
Main explanation
Under current IFRS 16 and US GAAP rules, most leases longer than a year appear on the balance sheet as a right-of-use asset and a matching lease liability.
Operating and finance leases differ mainly in how the cost appears in the income statement under US GAAP. Under IFRS almost all leases are treated like finance leases.
Under IFRS, rent expense is replaced by depreciation and interest, so EBITDA rises even though nothing changed economically. Comparing companies across standards needs care.
Lease-adjusted leverage adds lease liabilities to debt, and compares it with EBITDA including rent (EBITDAR) or with lease-adjusted EBITDA.
Lease payments are hard to cut in a downturn. Airlines, retailers and restaurant chains with heavy leases can face the same pressure as heavily indebted firms.
Example using a real company
Airlines lease many of their aircraft, and restaurant chains lease most of their sites, creating large lease liabilities.
- →Debt 2 billion plus lease liabilities 3 billion: lease-adjusted debt is 5 billion.
- →A retailer switching to IFRS 16 reports higher EBITDA because rent moves below the EBITDA line.
Common beginner mistakes
- ✕Looking only at bank debt and bonds.
- ✕Comparing EBITDA between IFRS and US GAAP companies without adjusting for leases.
- ✕Assuming leased assets carry no fixed obligation.
Key terms
- Lease liability
- The present value of future lease payments the company is committed to.
- Right-of-use asset
- The balance-sheet value of the right to use a leased asset.
- EBITDAR
- Earnings before interest, tax, depreciation, amortisation and rent.
Key takeaways
- 01Long leases are fixed obligations like debt.
- 02Lease accounting changes EBITDA without changing the business.
- 03Use lease-adjusted leverage for lease-heavy companies.
Check yourself
- 01Why can a long lease behave like debt?
- 02What two items does a lease create on the balance sheet?
- 03Why does EBITDA rise under IFRS 16?
- 04How do you calculate lease-adjusted debt?
- 05Which industries are most affected?
Try the concept on a real company
Open a restaurant or retail company in the Analyzer and check whether its debt figures include lease liabilities.
Educational examples only. Not buy or sell recommendations.