Quick Background On Lease Accounting
Anyone who was a financial analyst before 2019 was likely trained to adjust some version of operating income, enterprise value, and leverage ratio calculations for leases. Why? Before that time, lease expenses related to operating leases were simply expensed in the income statement, and there was zero accounting for them on the balance sheet. This meant that retailers that had made massive, sometimes decades-long commitments to landlords via property leases for their stores did not have to recognize these very real liabilities anywhere in their GAAP financials. In other words, they often had significant off-balance sheet liabilities and accounting rules did not require that they be recognized. This also made comparability between retailers and other businesses that owned property vs. their competitors that didn’t mostly useless. So, in 2019 FASB introduced IFRS 16/ASC 842 to address these issues by increasing transparency for operating leases in GAAP financials. The bottom line here is that post-2019, a company’s lease expense is reflected in the income statement and as an asset and liability on its balance sheet, so there is nowhere to hide this debt anymore. Many viewed this as a welcomed change.
Adjustments For ROIC
But to get a useful, accurate ROIC number for a company even in a post-ASC 842 world where operating leases are on-balance sheet rather than off, we still have to make some adjustments to GAAP numbers. Specifically, we have to add imputed interest expense from the lease liability back to EBIT before applying a tax rate to get to NOPAT. In most cases, i.e., where the company’s operating lease commitments are small vs. their overall asset bases, this adjustment is negligible. But for some businesses like retailers, especially those operating lease commitments comprise a very large chunk of their invested capital, the adjustment can be consequential to the ROIC reading, so it’s worth understanding how to do it. It’s also a good idea to understand where the balance sheet items for operating leases are coming from in thinking about ROIC.
Below, I am going to explain the basic income statement and balance sheet entries of operating lease accounting so that readers can understand these items when they see them in financials. I’ll then walk through an example (Bath & Beauty Works) and show the adjustment that needs to be made to EBIT to get an ROIC result that better reflects the economic reality of the company.
Let’s start with the balance sheet: ASC 842 requires firms to report the right-of-use asset (ROU) and the corresponding operating lease liability on the balance sheet.
The Operating Lease (ROU) Asset
The ROU asset on the balance sheet is initially calculated as the total lease liability amount (i.e., all the rent payments over the life of the lease(s)) discounted to present value using the company’s cost of capital, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred (e.g., commissions, legal fees), less any lease incentives received (e.g., free rent). Each period, this balance sheet amount (assuming no new leases) is reduced by the depreciation of the ROU, which is expensed in the income statement. Depreciation is calculated on a straight-line basis over the life of the lease(s) with no salvage value.
The Operating Lease Liability
This liability amount starts as the same amount as the ROU asset. Each year it is increased by an imputed interest cost and reduced by the lease payment. Imputed interest is the lease liability amount at the beginning of the period multiplied by the company’s cost of debt.
So, the income statement expense for operating leases is the sum of two parts: depreciation and imputed interest. Companies typically do not break out the two parts. The idea here is that GAAP is treating the leased property as if it was an asset that was purchased by the company using debt, so that there is a depreciation expense and an (imputed) interest expense running through the income statement related to the lease, and both an asset (hypothetical owned property) and liability (hypothetical mortgage) for that lease on the balance sheet. This way, the financial leverage (liability) and capital consumed/committed (asset) from operating leases are not omitted from financial statements, and readers get a much fuller picture of financial leverage and asset intensity.
If you want EBIT to reflect the true economic cost of operating leases, the imputed interest component should be added back to EBIT, because it’s a financing cost, not an operating cost. This amount is approximated by taking the lease liability and multiplying it by the cost of debt.
Example: Bath & Beauty Works (BBWI) Operating Lease Adjustments
Let’s run through it with BBWI, starting with the balance sheet:
From the 10K: “At lease commencement, the Company recognizes an asset for the right to use the leased asset and a liability based on the present value of the unpaid fixed lease payments.“
You can see that the operating lease liability of $177 (current liabilities) + $1,014 (long-term liabilities) = $1,191 is very close to the ROU asset of $1,050. The difference is some of the items that apply to the ROU but not the liability, discussed earlier. Note that the company picks up the operating lease liability and treats it like debt here:
Here’s a footnote on Leases from the financials in the same 10K:
The $1,191 PV of operating lease liabilities ties out to the balance sheet. Note also that just after this in the 10K it says that the cash paid for operating leases in 2022 was $249 which compares with the $382 number for Total Lease Cost above. So, there is a non-cash component of the lease cost, which includes imputed interest. As previously mentioned, we need to add that back to EBIT for calculating NOPAT for ROIC. That’s an approximation, which is simply the beginning-of-period operating lease liability multiplied by the cost of debt.
Here is how I did it:
The imputed interest is added back to EBIT to get to Adjusted EBIT, which is then reduced by taxes to get to NOPAT, which is the ROIC numerator. The operating lease asset from the balance sheet is included in invested capital as-is, which is the ROIC denominator. The build-up to NOPAT and all the numbers behind its ROIC are in this full BBWI post.