Leases, and the debt that was hidden
For decades, renting a building instead of buying it kept the obligation off the balance sheet entirely. The rules changed. The reason they changed is instructive.
A retailer with 500 leased stores has committed to pay rent for years. Until recently, none of that commitment appeared on the balance sheet — only a note at the back listing future payments.
The old distinction
- Finance lease — effectively a purchase funded by instalments. An asset and a matching debt appeared on the balance sheet.
- Operating lease — treated as renting. Only the annual rent hit the income statement; the multi-year obligation stayed in a footnote.
Contracts were routinely structured to land just on the operating side of the tests, because doing so kept reported debt lower and reported return on assets higher. The obligation was identical. The accounting treatment, and therefore the ratios lenders and investors watched, was not.
What changed
IFRS 16 and the US equivalent ASC 842, effective from 2019, require nearly all leases of more than a year to be recognised. A right-of-use asset appears, and a lease liability appears beside it.
Retailers, airlines and restaurant groups saw reported assets and reported debt rise sharply on adoption. Nothing about the companies changed — the same stores, the same aircraft, the same contracts. Only the disclosure did. Any comparison that straddles the adoption year needs care.
The effect on the numbers
- Debt rises. Leverage ratios worsen, sometimes materially. Loan covenants written before the change usually had to be renegotiated.
- EBITDA rises. Rent used to be an operating expense; now it splits into depreciation on the asset and interest on the liability, both of which sit below EBITDA. The measure improved because of an accounting change, which is a good reason to distrust EBITDA comparisons across the transition.
- Operating cash flow rises. The principal portion of lease payments moved to financing activities. Free cash flow, properly defined, did not improve.
What to do with it
Treat lease liabilities as debt, because that is what they are — a fixed, contracted claim ahead of shareholders. A retailer with little borrowing and enormous lease obligations is a leveraged business, and was one before the rules acknowledged it.
The wider lesson generalises: where an obligation sits in the accounts is a reporting decision, and the economics are unchanged by it. Ask what the company is committed to pay, not which statement the commitment is printed on. See debt and leverage.