DBRS Comments on New Rules for Operating Lease Accounting

DBRS Limited (DBRS) is commenting on the changes to the treatment of operating leases under the International Financial Reporting Standards (IFRS 16) and U.S. Generally Accepted Accounting Principles (GAAP (ASC 842)) beginning next year. In this commentary, which incorporates preliminary discussions with accounting specialists and market participants, DBRS provides an overview of the upcoming changes and thoughts on past and potential future DBRS approaches to capitalizing operating leases.

(1) CHANGES TO ACCOUNTING STANDARDS
Effective January 1, 2019, new accounting standards under IFRS 16 and GAAP (ASC 842) will effectively end the off-balance sheet treatment of operating leases, with certain exceptions such as small, short-term or variable payment leases or contingent rentals. Operating leases have historically been accounted for as off-balance sheet obligations in contrast to capital leases, which are accounted for as a liability on the balance sheet. The new accounting standards will trigger the recognition of an operating lease liability and a corresponding right-of-use asset on the balance sheet while also necessitating adjustments to income and cash flow statements, resulting in an increase in EBITDA and cash flow from operations. The new lease liability will be based on a present-value approach using discount rates meant to reflect the lease’s implicit rate or the lessee’s incremental borrowing costs. Outcomes from the application of the new accounting standards are expected to vary widely across industries, with those that have historically been heavier users of operating leases being most affected, notably retailers.

(2) CURRENT DBRS APPROACH
Investors, rating agencies and other market participants recognize the importance of operating leases when evaluating an issuer’s financial profile, as operating leases can exert the same pressure as traditional debt financing on a company’s financial resources. Accordingly, DBRS typically reflects operating leases in the credit metrics of an issuer by multiplying the next year’s total operating lease obligation by six and adding the product to the balance sheet debt to create a lease-adjusted debt equivalent. DBRS also adjusts interest and depreciation expenses to ensure better comparability of key income and cash-flow-statement-driven credit metrics. This approach assumes that assets under operating leases are important to the business and should be considered permanent in nature. More importantly, this simple and transparent approach brings some consistency to the treatment of debt and lease obligations, improving comparability between issuers that purchase equipment and property using debt financing versus those that employ operating leases to finance the same assets. Furthermore, a multiple approach helps address potential challenges posed by the possible subjectivity involved in the determination of the incremental borrowing rate and lease term used to quantify the off-balance sheet liability under a present-value approach.

(3) POTENTIAL CHALLENGES USING NEW ACCOUNTING STANDARDS FOR CREDIT RATINGS
While the intent of the new accounting standards is to provide greater transparency as it relates to lease obligations, DBRS notes that the figures reported for a particular operating lease may differ for two different lessees due to management discretion over certain underlying assumptions. For example, the accounting treatment of the term of an operating lease can be influenced by management’s assessment of the likelihood of exercising extension options or its decision to structure the obligation as a short-term lease with consistent renewals, while the discount rate selected by management as a proxy for the incremental borrowing costs of an entity can vary significantly.

Furthermore, upon implementation of IFRS 16 or GAAP (ASC 842), a company can opt for either a full retrospective or modified retrospective application of the standards, each of which could have a significant influence on the outcome. The full retrospective approach requires the historical application of the new rules for the lease and restatement of comparative financial statements, while the modified retrospective approach allows for the impact to be recognized only from the date of the initial application. The impact of the latter transition approach on the financing statements will not fully equate to that of the modified retrospective approach until the lease portfolio has fully renewed, which could be several years.

As a result, DBRS believes there may continue to be significant merits in using a multiple approach for analytical purposes, as this approach may ensure greater consistency across issuers and for individual issuers as the impact of a transition choice unwinds over time.

(4) DBRS APPROACH GOING FORWARD
As the new accounting standards are expected to result in substantial changes to financial reporting that cannot be fully ascertained at this time, DBRS plans to continue using the six-times multiple approach discussed above, to the extent possible, in the near term. DBRS will concurrently evaluate the existing multiple approach as well as the merits of the new accounting standards by tracking its implementation among large lease users in 2019.

Following DBRS’s review of the financial results released under the new accounting standards, DBRS will communicate further information on this topic when and as appropriate, including a possible request for comment, if necessary.

Note:
For more information, visit www.dbrs.com or contact us at info@dbrs.com.