The last couple years have seen significant changes in the U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) treatment of leases, and in particular of operating leases. The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification Topic 842: “Leases” (ASC 842) in 2016. The new standard became effective for public companies for accounting periods beginning after Dec. 15, 2018, and replaced the earlier guidance under ASC 840. Therefore, for public calendar-year companies the first year reported under the new rules is the year ended Dec. 31, 2019. Given that public filings for this year are already available, we now have initial data to evaluate how ASC 842 has affected commonly used profit metrics in the transfer pricing field and draw recommendations if the new standard merits any adjustments to existing transfer pricing benchmarking approaches.
In parallel, the International Accounting Standards Board (IASB) issued new guidance under IFRS 16: Leases, which replaced the earlier guidance in IAS17. IFRS 16 is also effective for periods beginning after Jan. 1, 2019. Therefore, the 2019 calendar year is also the first year with IFRS data available to assess the impact of the accounting change.
For both U.S. GAAP and IFRS, the main motivation for the new standards was to improve the representation of companies’ leverage in their financial statements. In that regard, the major impact of both standards is that leases previously classified as operating leases are now explicitly recognized on the balance sheet with a right-of-use (ROU) asset and a lease liability rather than disclosed as off-balance sheet commitments. However, while the new U.S. GAAP standard recognizes operating leases on the balance sheet and retained operating lease classification (separate from finance leases), it did not revise the representation of operating lease expense on the income statement.
By contrast, IFRS eliminated the concept of an operating lease; all leases are now accounted for in the manner of finance leases under the legacy IFRS standard (IAS 17). Because of this, formerly operating lease expense is now segregated into interest expense and depreciation, thereby affecting the income statement (classification and timing) as well as the balance sheet (as discussed further below, while the accounting standard changes seem to have increased consistency among U.S. GAAP filing companies and among IFRS filing companies, consistency between U.S. GAAP companies and IFRS companies has diminished).
The lease standard changes have raised certain questions in the transfer pricing field about best practices for the use of databases of comparables for benchmarking purposes (i.e., companies with public filings, which practitioners frequently source from commercial databases to inform a typical profit range for a specific business activity). First, common asset- or capital-based profit level indicators such as the return on assets (defined as operating income divided by total assets) or variations thereof may be significantly impacted by the addition of ROU assets previously disclosed off-balance sheet.
Second, even an indicator such as the commonly used operating margin (defined as operating income divided by revenue), which in theory does not depend on balance sheet items, could appear very different solely due to a company’s choice to report under U.S. GAAP or IFRS.
Third, both U.S. GAAP and IFRS have mandated testing the newly recognized ROU assets for impairment as long-lived assets. Any potential impairment charges would be considered as an operating expense and as such evaluating potential comparable data may require additional scrutiny. In summary, the new accounting standard developments have introduced greater possibilities that the comparability of financial data from benchmarking databases may be diminished.
The objective of this article is to evaluate the early evidence from the adoption of the new standards and draw preliminary insights about the most likely situations where the use of financial data from benchmarking databases may require additional considerations or adjustments. Given the considerable efforts to implement the new standards from accounting perspective, most companies did not elect early adoption. As such, for most public companies calendar 2019 is the first year reported under the new rules. The article compares 2019 public filings data (new standards) to 2017-2018 data (old standards) to evaluate the magnitude of the changes by industry segment. The focus of the analysis is on the impact for lessees (both the U.S. GAAP and IFRS standards introduced changes into lessor accounting as well, but these changes are outside the scope of the analysis presented herein). The main conclusions that emerge from this evaluation are as follows:
- The most significant financial statement changes are concentrated in the consumer discretionary sector (many retailer businesses have recognized significant ROU assets and lease liabilities in 2019) but some services providers are also among the most affected companies
- For companies reporting under U.S. GAAP, income statement based profit indicators (e.g., operating margin) are generally not affected by the change
- For U.S. GAAP companies, asset or capital based profit indicators (e.g., return on assets) have generally fallen for industries with a large proportion of previously off-balance sheet arrangements; however, some adjustments can be made to account for inconsistently reported years during the transition period
- For IFRS companies, both key income statement line items (such as operating income, for example) and the reported assets on the balance sheet have changed; in general IFRS data will not be comparable to U.S. GAAP data and adjustments to IFRS financial statements will be difficult to make solely based on public filings
- If benchmarking analyses require a mix of U.S. GAAP and IFRS comparables, some modifications to traditional transfer pricing profit level indicators are discussed which could retain comparability across the two accounting standards
We next turn to describing briefly the main accounting changes most relevant to transfer pricing benchmarks.
Overview of ASC 842
ASC 842 was developed primarily to improve financial statement users’ understanding of lessees’ lease obligations. The main intended benefits of the lease standard change included:
- Greater transparency in the representation of rights and obligations arising from leases;
- Improved understanding and comparability of lessees’ financial commitments regardless of how lessees finance the assets used in their business; and
- Reduction of opportunities to structure leases to achieve a particular balance sheet outcome
From a measurement perspective, ASC 842 requires that lessees measure their operating lease liability at the present value of the unpaid lease payments discounted at the rate implicit in the lease if it is readily determinable. Since in most circumstances the rate implicit in the lease will not be readily determinable by lessees, lessees typically use as the discount rate for their leases their incremental borrowing rate (IBR). For practical purposes, the IBR can be seen as a lessee’s secured borrowing rate, with the logic behind being that a lease can be seen as a secured obligation given it is collateralized by the leased asset. On the other hand, while the ROU asset measurement initially also includes the present value of the lease payments, it further adds the initial direct costs of the lease and prepayments, minus lease incentives. Hence, even at the initial point of the lease the ROU asset may not equal the lease liability. Over the life of the lease, ROU assets are subject to impairment and in some cases, accelerated amortization, so the value of the ROU asset recognized may further depart from the value of the lease liability.
From an income statement perspective, U.S. GAAP companies would still report a single, operating lease expense as under the preceding ASC 840 guidance (with the possible difference that under ASC 842 ROU asset impairments losses may be reflected whereas previously ROU assets did not exist to impair). Table 1 below summarizes the finance and operating leases under the new ASC 842.
TABLE 1. U.S. GAAP Financial Statement Impact of ASC 842
ASC 842 also introduces specific rules for the transition from ASC 840. In practice, most companies have followed an “effective date approach” under which prior financial years have not been restated to show ROU assets and lease liabilities. Instead, the first year in which ROU assets and lease liabilities are recorded on the balance sheet is the adoption year (2019 for U.S. public companies); the cumulative effect of the transition on all past years is recorded directly into the statement of changes in stockholder’s equity as of the company’s adoption date (e.g. Jan. 1, 2019). As such, even for the same company, the 2019 balance sheet would not be comparable to the 2018 balance sheet.
Overview of IFRS16
The IASB issued IFRS 16 Leases in January 2016 and the new standard applies to reporting periods beginning on or after Jan. 1, 2019. An important difference from ASC 842 is that while the separation of finance vs. operating leases for lessors is maintained, the separation between the two lease classifications for lessees no longer applies. In effect, IFRS 16 requires lessees to account for all leases in the manner that finance leases were accounted for under the preceding IAS 17. Instead of recognizing a single operating lease expense (as U.S. GAAP companies would continue to do under ASC 842 for leases that would be classified as operating leases thereunder), IFRS companies would need to impute interest expense associated with the lease liability (on an effective interest method) and record depreciation of the ROU asset. Therefore, in addition to recognizing ROU assets and lease liabilities on the balance sheet, companies reporting under IFRS would also see a shift of operating expenses below line items such as EBITDA (for depreciation) and EBIT (for interest expense).
Table 2 below illustrates the difference between IAS 17 and IFRS 16 using as an example a hypothetical five-year lease with $200 annual payments. The example assumes that the discount rate for the lease is 5%. Depreciation of the ROU asset is on a five-year straight line basis.
TABLE 2. Example of IFRS 16 Treatment of Operating Lease
Under IAS 17 or ASC 842, the lessee would record $200 operating lease expense in Years 1-5 for a total of $1000. In contrast, under IFRS 16 the lessee would first calculate the present value of the lease payments using the 5% discount rate for the lease. Therefore, an initial liability of $866 would be recorded which equals five years of $200 payments discounted at 5%. The Year 1 interest expense is calculated as the initial liability of $866 times 5%; over time the liability and interest expense will decrease similarly to a mortgage amortization schedule. Depreciation is derived by dividing the initial lease PV of $866 by 5 years. We can then compare on yearly basis how net income and EBIT would change due to the new accounting standard.
The example leads to two important observations. First, while over the five-year period the lessee would experience the same total net income under IFRS 16 as it did under IAS 17 or would under ASC 842, there is a timing difference as expenses under IFRS 16 are front-loaded due to the interest incurred on the lease liability. As each lease may be depreciated on a different schedule, generally it will not be possible to adjust IFRS 16 financial statements back to an IAS 17 presentation solely based on information available in public filings.
Second, and of greater importance for a transfer pricing analysis, EBIT would see a positive change as depreciation will be less than the operating lease expense (i.e., some of the above-the-line expense under IAS 17 or ASC 842 is transferred below-the-line as imputed interest expense). Moreover, the EBIT change never reverses, so it would remain even if a longer multiyear period is considered. As EBIT affects the vast majority of transfer pricing profit metrics used by practitioners (e.g., operating margin, net cost plus, return on assets, etc.), IFRS 16 and ASC 842 data will be inherently not comparable, at least in cases where operating leases are material.
Data and Exploratory Analysis
We next turn to exploring a broad sample of companies with public filings to examine how the new accounting standards have translated into financial statement changes in practice. Based on certain materiality thresholds (at least $100 million revenue and $150 million total assets for 2019) and data completeness requirements (i.e., no missing revenue, operating income or total assets data for the three-year period 2017-2019), we identified 9,239 public companies that report under either U.S. GAAP (2,275 companies) or IFRS (6,964 companies). This data was sourced from S&P’s Capital IQ database (S&P Capital IQ. (2010)); each company is also associated with a specific primary industry and primary sector where it operates.
We first consider which industries have experienced the most significant changes to their balance sheet as result of recording ROU assets for the 2019 post-transition year. For companies reporting under U.S. GAAP, this assessment is easier because operating leases are retained as a separate category, distinct from finance leases. Table 3 below shows by industry the average proportion of total assets for 2019 that reflected previously off-balance sheet arrangements. This ROU asset proportion is simply not recorded on the 2018 balance sheet due to prevalence of the effective date approach.
TABLE 3. Recognized ROU Assets for U.S.GAAP Companies under ASC 842
Most industries in the top 25 are retailers who traditionally have relied more heavily on operating leases. However, some services sectors which traditionally are not thought of as asset-heavy are also represented in the top 25 list. For the Apparel Retail category, ROU assets reflect 40.8% of total assets. This implies a return on assets profit indicator from 2018 (and before) to 2019 (and after) would fall by about 40% simply due to accounting changes with the same underlying economics.
For IFRS companies identifying the proportion of assets under operating lease is not straightforward as IFRS 17 reports together all capital and operating leases under one single category, “leases.” Nonetheless, companies with greater leases may also be indicative of which companies may have more operating leases too. Table 4 below reports the top 25 industries by ROU assets recorded in 2019 for the surveyed IFRS sample.
TABLE 4. ROU Assets for IFRS Companies under IFRS 17
Based on the IFRS data, which as explained doesn’t have one-to-one correspondence with the U.S. GAAP definitions, it does appear that consumer discretionary industries and certain services providers dominate the top 25 list as well.
What is also clear is that for many of the 140+ industries as defined in the data sample, the impact may not be as significant. Intuitively, database comparables with higher proportion of ROU assets should experience a more significant shift from their 2017-2018 profit metrics to 2019 solely based on the accounting changes.
Figure 1 below shows the relationship observed in the U.S. GAAP data between the return on assets and level of ROU assets recognized by industry. Namely, the figure plots: (i) on the horizontal axis, the median percentage that ROU assets represent of total assets in 2019; and (ii) on the vertical axis, the median change in return on assets from the 2017-2018 average to 2019, again by industry. The inverse linear trend is also plotted (i.e., the blue line).
FIGURE 1. ROA Change by ROU Assets Size for U.S. GAAP Companies
For example, in 2019 the median ROU Assets/Total Assets ratio for companies in the Apparel Retail industry was about 40% (i.e., previously off-balance sheet assets now represent 40% of the total assets). Looking at how the ROA change for Apparel Retail companies from 2017-2018 to 2019, the median company saw a four percentage point drop (in this particular case, the median ROA for Apparel Retail companies dropped from 11% average in 2017-2018 to 7% in 2019).
These observations lead us to the first recommendation based on the exploratory analysis; namely, not all industries use operating leases to the same extent, so the starting point for comparability analysis should be assessing if operating leases are likely to be a significant factor (as a further point not all industries have same asset intensity in general). If the answer is yes, adjustments may be required as detailed further below. For at least some industries with minor ROU asset additions, transfer pricing practitioners can probably rely on outlier reducing concepts such as the commonly-used interquartile range, but for other industries greater due diligence than before would be needed to ensure the financial statements are not significantly affected by accounting choices.
Potential Adjustments for U.S.GAAP Companies
We have explained that for companies reporting under U.S. GAAP, income statement based profit indicators (e.g., operating margin) are generally not affected by the change with the exception of impairments. However, as shown in Figure 1 asset-based profit indicators (e.g., return on assets) have generally fallen for industries with large proportion of previously off-balance sheet arrangements. If U.S. GAAP companies were generally restating the comparative historical period in their public filings, that would have been less of a concern for a transfer pricing analysis relying on database benchmarks. Transfer pricing studies frequently look at multiple year averages to smoothen year-on-year fluctuations in industry profitability. If all past data was restated according to ASC 842, inferences from a three-year average would be valid as long as the tested entity also reports on the same basis.
However, the prevalence of the effective date approach to the implementation of ASC 842 introduces complications due to the inconsistent presentation of 2019 and all prior years. A three-year average benchmark for the 2017-2019 period would be based on two years reported under ASC 840 and one year under ASC 842. Naturally, there are two possibilities to address the inconsistency:
- Adjust the 2017-2018 years to reflect a presentation of operating leases under ASC 842
- “Reverse out” ASC 842 and adjust the 2019 data back to the old standard
We explore both options. The first option is preferable theoretically as ASC 842 ensures greater consistency in the reporting of leases. For a transfer pricing analysis, having all leases reported on the balance sheet consistently across benchmark companies would inform more precisely the relation between the assets or invested capital and profits generated. Historically, such adjustments to “add back” operating leases to the balance sheet have frequently been performed by equity research analysts interested in a fairer representation of companies’ leverage. The approach is outlined for example by Damodaran (2002) and involves several steps (see Damodaran, Aswath. 2002. Investment Valuation. New York: Wiley Finance.):
- Identify the projected minimum operating lease payments disclosed in the financial footnotes
- Build a cash outflow projection for these payments—payments aggregated under the last reported year “and thereafter” are usually spread out based on the run rate from the preceding year until they deplete the remaining balance
- Discount these cash flow rates at the company’s borrowing rate
The ensuing present value can be added to the asset side of the balance sheet as a reasonable approximation of what the ASC 842 view would be. Table 5 below provides an illustrative example of this adjustment.
TABLE 5. Adjustments to 2017-2018 GAAP Financials for Operating Leases
The downside of this approach may be that it could be computationally burdensome although commercial databases report in systematized format all necessary data extracted from the financial footnotes of public filings.
The second and simpler option is to “adjust back” the 2019 year. This can be accomplished simply by removing the ROU assets from the balance sheet which would make total assets comparable to their 2017-2018 presentation. A consistent three-year average can then be calculated. The downside of this approach is that it would miss any contributions to a company’s profitability from off-balance sheet arrangements, but that situation is no worse than performing the analysis prior to ASC 842 without an adjustment to add back off-balance sheet leases.
Both options can be a workable solution for the transition period. From 2021 onward, a three-year average would be based entirely on data reported under ASC 842 so no consistency issues should arise. Furthermore, no special adjustments would be required for profit metrics based solely on U.S. GAAP income statements.
Potential Approaches for Continued GAAP-IFRS Comparability
With regard to IFRS companies, two issues merit attention. First, transition period adjustments from IFRS 16 back to IAS 17 are not straightforward. Since IFRS 16 does away with the distinction between finance and operating leases which are now reported into a single category, there is easy no way to reverse out the operating lease portion only from the balance sheet.
The other option—adding the present value of operating lease commitments to the 2017-2018 years reported under IAS 17—is still a possibility. However, the adjustment is more complex than the U.S. GAAP case described above. Since IFRS 16 breaks the operating lease payment into imputed interest and depreciation, a similar adjustment needs to be made to the IAS 17 years to ensure that operating income is also reported on a consistent basis. Once the present value of the operating leases for 2017-2018 is identified, an interest expense can be imputed by multiplying the present value by the company’s borrowing rate; the residual between the IAS 17 lease operating expense and the imputed interest may be assigned to depreciation. However, this will still only lead to an approximation of the IFRS 16 treatment.
Second, when it comes to ensuring that U.S. GAAP and IFRS reporting companies can be adjusted to a consistent basis, such an adjustment would not be truly possible in the future due to the elimination of the separate finance and operating lease categories under IFRS 16 from 2019 onward. As shown in Table 2, there will be permanent changes in EBIT under IFRS 16 and ASC 842 that will not average out over a multiple year period.
One possibility is to attempt to impute the interest expense for operating leases for U.S. GAAP companies based on estimates of the IBR. Similarly to the adjustment from IAS 17 to IFRS 16 described above, this would approximate fully “converting” an ASC 842 operating lease into a finance lease and relocating the operating expense associated with lease payments to interest and depreciation. Computationally this may be quite burdensome although automation may reduce the effort required.
Another possibility is to add back the interest expense from an IFRS company to EBIT when comparing to a U.S. GAAP company. However, it may be challenging to isolate interest expense due to operating leases from interest expense due to borrowings, at least when it comes to the comparable companies (this would be easier for the tested party). Perhaps a simpler solution may be to focus on profit metrics that will remain consistent under ASC 842 and IFRS 16. One such example is “EBITDAR” or earnings before interest, tax, depreciation, amortization and rental expense. Unlike the popular EBITDA metric, EBITDAR also excludes operating lease payments.
For companies reporting under IFRS 16, EBITDAR and EBITDA are equivalent since no rental expense is going to be reported in the future. For U.S. GAAP companies, adjusting from EBITDA to EBITDAR requires only one extra step (i.e., add back the rental expense). Since both EBITDAR and the assets from the balance sheet are consistent between IFRS 16 and ASC 842, it is possible to define a number of profit metrics that would allow for valid comparisons among companies reporting under the different standards:
- Instead of operating margin, the EBITDAR margin can be considered defined as EBITDAR/Revenue
- Instead of ROA, the EBITDAR/Assets ratio can be considered
If such approach is taken, transfer pricing practitioners should also ensure based on qualitative information that the database comparables and tested entity employ similar levels of assets with similar age and other important characteristics. EBITDAR-based metrics will be consistent across U.S. GAAP and IFRS, but if the tested party employs a different level of assets from the benchmarking companies, comparability may still be insufficient.
This article has attempted to explore the effects on transfer pricing benchmarking exercises from the adoption of the new leasing standards under U.S. GAAP and IFRS. After the transition period is over and all relevant current and historical years are reported on the new basis, no major concerns should remain for ensuring valid comparisons among U.S. GAAP companies only or among IFRS companies only.
For many industries which did not rely significantly on off-balance sheet arrangements before, the accounting changes may not affect significantly transfer pricing profit metrics. However, companies in the consumer discretionary space and various services segments may be affected significantly.
During the transition period when companies report some years under the new standards and some years under old standards, caution is needed when calculating multiyear averages for commonly used transfer pricing metrics. This article provided several recommendations how to think about appropriate adjustments to ensure consistency during the transition period.
Finally, going forward comparisons between U.S. GAAP and IFRS companies will be affected due to the IASB’s decision to eliminate altogether the distinction between finance and operating leases. While the article recommended some possibilities to mitigate this problem, U.S. GAAP to IFRS comparability for transfer pricing analyses in the future will be lower under ASC 842 and IFRS 16 than under the legacy ASC 840 and IAS 17 standards if operating leases are significant to the business.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Valentin Krustev is a senior manager in the Economic and Valuation Services practice of KPMG LLP.
The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.
The author would like to acknowledge the helpful contributions and comments of Prita Subramanian and Bob Clair.