Question on operating leases under US-GAAP
Under IFRS 16, we know that both, operating and financing leases are recognized on the BS and separated into their interest and depreciation component on the IS, with an additional lease repayment which is the difference of the cash lease expense and the interest expense.
Under US-GAAP there is no such split. We recognize the rental expense on the IS and then record two adjustments on the CFS (depreciation and principal repayment) which balance each other out.
However, the cash lease expense can differ from the straight-line IS expense (e.g., 200 cash payment over 10 years, so 20 straight-line on the IS each year, but we pay 12 in cash first year, 14 in second year, etc.)
My question here is best illustrated with an example:
20 IS rental expense
12 cash lease payment
9 interest payment (calculated as discount rate * NPV of all cash flows)
3 depreciation component (cash lease payment minus interest payment, per definition)
11 principal repayment (IS rental expense minus interest payment, per definition)
So net income would be -20 assuming no taxes.
CFS:
-20 net income
+3 depreciation (following the same reversal treatment as if cash expense = IS expense)
-11 principal repayment (following the same reversal treatment as if cash expense = IS expense)
= -28 cash flow
BS:
Asset:
-3 RoU asset
-28 cash flow
L&E:
-20 net income
-11 lease liability
So both sides are down by -33 in year 1. However, now the cash flow is materially higher vs. the envisaged cash payment of -12 in year 1. So I guess there must be a deferred item on the cash flow statement to reverse this (e.g., a liability created of 16, when recognizing the IS expense).
This is were things get messy. When / how do we record such deferred liability of 16 / do we have to do so at all? What is the correct treatment under US-GAAP?
This would then be a +16 CFS adjustment, leading to the -12 of cash flow. But this is just something I made up as a possible solution because I can’t find another way to make everything balance.
Help is kindly appreciated here – thanks!
Your entire example is wrong. It's been a while since I took financial claims but I'll take a crack.
IFRS: All leases are finance leases. IS shows interest and depreciation, CFS shows interest and principal.
Under GAAP, operating leases put an ROU asset and lease liability on the BS, but GAAP hides the financing nature on the IS. Instead of showing interest and depreciation separately, GAAP combines interest and the ROU Asset amortization into a single straight-line expense. This doesn't mean that interest and amortization don't exist economically. These amounts exist internally to update the lease liability and ROU asset balances each period, but they never appear separately on the IS or CFS for an operating lease. For this exact reason, all cash lease payments are operating cashflows (hence why it's called an operating lease), and there is no concept of "principal repayment" which would be a financing CF. In your example, you're basically trying to back in to the interest, depreciation, and principal on the cashflow statement which is implicitly forcing the operating lease into a finance lease. That's why your numbers don't add up and why you had to invent a deferred liability to fix the imbalance. No such imbalance exists.
Proper numbers for your example:
Straight-line lease expense (IS): 20
Cash paid (y1): 12
Imputed interest (internal): 9
ROU asset amortization (internal): 11 (because 20-9=11)
JE to record straight-line lease expense
Dr. Lease expense 20
Cr. Operating lease liability 9
Cr. ROU asset (amortization) 11
(this records the required IS expense of 20, internally accretes the lease liability by interest (9) and amortizes the ROU asset (11))
JE to record cash lease payment
Dr. Operating lease liability 12
Cr. Cash 12
(this reflects actual cash paid, and debiting OLL reduces the lease liability)
So, net balance sheet effect for the period: +9 (interest accretion), -12 (cash payment). Net change: -3.
ROU asset is -11 (amortization), Cash is -12, Retained earnings is -20 (from lease expense).
From the CFS perspective, net income is -20, but only -12 of that is an actual cash outflow in the period. The remaining -8 is non-cash and reflects the net change in the operating lease ROU asset and lease liability. Therefore, operating CF is -12, with a +8 non-cash operating lease adjustment (plug) to reconcile net income to cash. There is no financing cash flow, no principal repayment, and no deferred liability. Now I can put it into your original format:
IS
Lease expense: 20
Net income: -20
CFS (Operating)
Cash paid for operating lease: -12
Non-cash operating lease adjustment (plug): +8
Net operating cash flow impact: -12
BS
ROU asset -11 (lease expense 20 - internal interest 9)
Lease liability: -3 (internal interest 9 - cash paid 12)
Cash: -12
Retained earnings: -20
So total assets are -23, total L&E are -23.
Operating leases are very complex. I would suggest googling "operating vs. finance lease tree". PWC made a really good one. But basically since this shit is so complicated we don't even spend much time modeling GAAP operating lease mechanics in a DCF. Operating leases produce a single operating expense on the IS and an operating cash outflow equal to cash paid, so they leave little impact on UFCF beyond what is already captured in EBITDA.
Legendary post, thanks a lot for that, very clear.
Just one follow-up question.
My source was the BIWS guides. They show this:
They state that lease depreciation is based on cash lease expense minus interest, which is why I got the -3 instead of your -11. This is wrong then I assume?
hmm, BIWS isn't inherently wrong but the terminology is a bit sloppy. The formulas they give are the "internal" B/S mechanics, not CFS or IS logic which makes it easy to misapply and already assumes you understand the distinction.
"Lease depreciation equals the cash lease expense minus interest expense" is only accurate if "cash lease expense" means the straight-line lease expense, not the actual cash payment. If someone misinterprets it as cash paid, they get 12-9=3, which implies an ROU asset reduction of 3. That's wrong and leads to the problem you encountered. Straight-line lease expense - interest gets you 20-9=11, which is correct.
What BIWS is trying to say is
Lease liability is:
Interest (9) - cash paid (12) = -3
ROU Asset (this is the lease depreciation they're talking about) is:
-(lease expense - interest)
-(20-9)
=-11
Side note "lease depreciation" should technically be "ROU asset amortization" to be more clear. "Lease depreciation" is what they are using for the balance sheet reduction of the ROU Asset that is required to make the straight-line lease expense method work.
Thanks a lot, that's super helpful and I am happy to now grasp this topic in a better way.
Just trying my luck here, are you by any chance also knowledgable about accounting of SBCs and their tax benefits and could check out my other threat: /forum/investment-banking/excessgeneral-tax-benefits-from-stock-based-compensation-0
Thanks in any case!
I'll take a gander!
Great post, SB+
This is the kind of content that made this site a must have in finance. This and, of course, the exchange and banter on economic topics and usual off topic on cars, places, clothes etc.
@AndyLouis and Patrick, how can this content be in incentivised? Less outrageous posts on topics of questionable interest and benefit for the community, particularly the young ones...
Thank you, highly appreciated!
I’m not sure what we are missing here but for an op lease this isn’t a complex recording. On the is you would book y1 rent expense, and then on the balance sheet you’d book pv of lease payments and pv of any residual value as an rou on asset side and the same as lease liability on l/e portion. We don’t need to complicate this folks
Recusandae accusamus autem tenetur et. Aspernatur et qui tenetur. Accusantium in mollitia ipsam blanditiis dolorem sed.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...