Accounting Standards

ASC 842 and IFRS 16 Leases: Effect on EBITDA and Leverage

ASC 842 and IFRS 16 require lessees to record most leases on the balance sheet as a right-of-use asset and lease liability. Under IFRS 16 nearly all leases are financing-like, so rent leaves EBITDA and becomes depreciation and interest. Under ASC 842 operating leases keep a single straight-line rent expense within EBITDA. Underwriters must align definitions before comparing leverage.

What changed under ASC 842 and IFRS 16?

Before the current standards, operating leases were largely off balance sheet. Companies disclosed future rent commitments in notes, and analysts often capitalized them using rules of thumb to compare leverage across companies that leased versus owned assets. ASC 842 and IFRS 16 now require lessees to recognize a right-of-use asset and a lease liability for most leases longer than twelve months, measured at the present value of remaining lease payments discounted at the rate implicit in the lease or the lessee's incremental borrowing rate.

The balance sheet effect is similar under both standards. The income statement effect is not. IFRS 16 uses a single lessee model in which every recognized lease is treated like a financed asset purchase, producing depreciation and interest expense. ASC 842 retains two categories: finance leases, treated much like IFRS 16, and operating leases, which keep a single straight-line lease cost in operating expenses. That difference flows directly into EBITDA, operating cash flow and every ratio built on them, which is why cross-border comparisons require explicit adjustment.

How is the lease liability measured?

The lease liability equals the present value of the lease payments not yet paid, including fixed payments, in-substance fixed payments, variable payments tied to an index or rate measured at the current index, the exercise price of purchase options reasonably certain to be exercised, and penalties for termination if termination is expected. Variable payments based on usage or sales, such as percentage rent, are excluded and expensed as incurred. The term includes renewal periods the lessee is reasonably certain to exercise.

The discount rate is the rate implicit in the lease if readily determinable, which is rare for lessees, so most use their incremental borrowing rate: the rate they would pay to borrow on a collateralized basis over a similar term. Private companies under US GAAP may elect a risk-free rate, which produces a larger liability. The right-of-use asset starts at the liability amount plus initial direct costs and prepaid rent, less incentives received. Judgments on term and rate can materially change the reported liability and should be reviewed.

Why does EBITDA differ between ASC 842 and IFRS 16?

Under IFRS 16, lease payments are split into depreciation of the right-of-use asset and interest on the lease liability, both of which sit below EBITDA. EBITDA therefore rises by roughly the amount of rent, compared with a company reporting under ASC 842 with operating leases, where straight-line rent remains an operating expense. Operating cash flow also rises under IFRS 16 because the principal portion of lease payments is classified as financing, while under ASC 842 operating lease payments stay in operating activities.

Total expense also differs in timing. IFRS 16 front-loads lease cost because interest is highest early in the lease when the liability is largest, whereas ASC 842 operating lease cost is level. Over the full lease term the totals are equal. For lease-heavy businesses such as retailers, restaurants, logistics and healthcare providers, these effects are large enough to change valuation multiples, leverage ratios and covenant compliance, so underwriters must know which basis the numbers use. Peer comparisons that mix reporting frameworks without adjustment can therefore point to the wrong conclusion about relative profitability and leverage.

How should leases be treated in leverage and coverage ratios?

The key principle is consistency between numerator and denominator. If EBITDA excludes rent, as under IFRS 16, debt should include lease liabilities. If EBITDA is after rent, as under ASC 842 operating leases, debt should generally exclude operating lease liabilities, or the analyst should use an EBITDAR-based measure that adds rent back and includes capitalized leases in debt. Mixing a post-IFRS 16 EBITDA with debt that excludes leases understates leverage significantly for lease-intensive borrowers. When comparing a borrower with peers, restate all of them to the same lease treatment before drawing conclusions. A borrower that looks modestly levered on an IFRS basis may look much more levered once rent is restored to operating costs and lease liabilities are excluded, or the reverse.

Many credit agreements address this explicitly, often freezing accounting definitions at a date before the standards took effect or defining which lease liabilities count as debt. Fixed charge coverage ratios commonly include rent in fixed charges, which produces a more consistent view across standards. Underwriters should read the definitions carefully and calculate ratios on their own consistent basis. Lease-adjusted leverage is especially useful for comparing a company that owns its real estate with one that leases equivalent space, because it puts both on the same footing.

What should underwriters review in lease diligence?

Obtain a lease schedule listing each lease with its term, renewal options, payments, escalations and discount rate, and reconcile it to the reported liability. Review whether renewal options have been included or excluded consistently and whether the incremental borrowing rate is reasonable for the borrower's credit profile. Check for leases with related parties, which may carry off-market terms or be eliminated or renegotiated in a transaction. Underwriters should also ask whether any leases are guaranteed by the parent or owners, since guarantees can shift obligations within a group, and whether sale-leaseback transactions have been used to raise cash. A sale-leaseback converts an owned asset into a long-term fixed obligation and can inflate near-term liquidity while increasing lease-adjusted leverage, which is a pattern worth flagging in the credit memo.

Also review lease maturities against the business plan. A cluster of expiring leases may require relocation capital or bring rent resets that change margins. Variable rent arrangements excluded from the liability can still be significant cash obligations. Change-of-control clauses and landlord consent requirements can affect an acquisition timeline. For collateral purposes, right-of-use assets typically have limited recovery value because they cannot be sold separately from the lease, so they should not be relied upon as security in a lending decision.

One lease under ASC 842 operating treatment and IFRS 16

1. Five-year lease, annual payments of $100,000 in arrears, incremental borrowing rate 6%.
2. Annuity factor = (1 - 1.06^-5) / 0.06 = (1 - 0.7473) / 0.06 = 4.2124. Lease liability = 100,000 x 4.2124 = $421,236.
3. ASC 842 operating lease: year-one lease cost = $100,000, recorded in operating expenses and within EBITDA.
4. IFRS 16: depreciation = 421,236 / 5 = $84,247; interest = 421,236 x 6% = $25,274. Year-one expense = $109,521, all below EBITDA.
5. Company-level effect: EBITDA under ASC 842 = $2,000,000 with funded debt $6,000,000, leverage = 3.00x. Under IFRS 16, EBITDA = $2,100,000 and debt including the lease = $6,421,236, leverage = 6,421,236 / 2,100,000 = 3.06x.
6. Year-one pre-tax income is $9,521 lower under IFRS 16, while EBITDA is $100,000 higher; over the five years total expense is equal at $500,000.

How underwriters apply this

• Identify whether reported EBITDA is pre-rent or post-rent before applying any multiple or leverage threshold.
• Pair EBITDA and debt consistently, or use EBITDAR with lease-adjusted debt for lease-heavy borrowers.
• Read the credit agreement for frozen GAAP or specific lease definitions before testing covenants.
• Reconcile the lease schedule to the liability and review renewal assumptions and discount rates.
• Do not treat right-of-use assets as recoverable collateral.

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