In a transfer pricing analysis, the tested party’s profitability indicator is compared to that of independent companies that should be measured under the same rules. Since 2019, International Financial Reporting Standard 16 (IFRS 16) changed the way lessees account for their leases. This shift can alter the operating margin of a Latin American subsidiary even if its functions, assets, and economic risks remain unchanged. For Transfer Pricing specialists, the fundamental question is not an accounting one, but one of comparability: are we comparing the same measure of profit?
What changed with IFRS 16?
IFRS 16 applies to annual reporting periods beginning on or after January 1, 2019, with early adoption permitted, replacing International Accounting Standard 17 (IAS 17). Under the new standard, the lessee generally recognizes a right-of-use asset and a lease liability, subject to certain exemptions, such as short-term leases and leases of low-value underlying assets.
In the income statement, the rental expense previously included in operating expenses is generally replaced by two-line items. The depreciation of the right-of-use asset remains within operating profit, while the interest on the lease liability is presented as a finance expense, below operating profit. The business remains the same, but a portion of the cost of using offices, warehouses, vehicles, or equipment shifts lines.
How does the profitability metric change?
In a hypothetical example, a distributor’s operating margin rises from 2.00% to 2.55% simply by applying IFRS 16. The distributor leases a warehouse for five years, with an annual payment of 500 at the end of each period and a discount rate of 4%. The initial liability is approximately 2,226; the annual straight-line depreciation of the right-of-use asset is 445; and the interest for the first year is 89.
| Description (in thousands of USD) | With IFRS 16 | Without IFRS 16 |
| Sales | 10,000 | 10,000 |
| Cost of goods sold | 7,000 | 7,000 |
| Operating expenses without rent | 2,300 | 2,300 |
| Rental expenses | 500 | 0 |
| Depreciation of the right-of-use | 0 | 445 |
| Operating profit | 200 | 255 |
| Operating margin | 2.00 % | 2.55 % |
| Margin on operating costs and expenses | 2.04 % | 2.62 % |
Note: The figures in the example are rounded and correspond to the first year of the lease.
The 89 interest points are excluded from operating profit. If the interquartile range of comparables were, for example 2.20% to 4.00%, the exact same company would go from falling outside the range to falling within it without any change in its operations.
The effect is not limited to the operating margin. Return on assets may decrease due to the recognition of the right-of-use asset, while the Berry Ratio may also be affected by changes in operating expenses. The magnitude and direction of these changes will depend on the company’s financial structure and the definition of the profit level indicator used.
Why does it affect comparability?
The issue arises when the tested party and the comparable companies do not measure operating income using the same framework. A search for comparables may yield a set that includes companies reporting under IFRS alongside companies reporting under U.S. Generally Accepted Accounting Principles (U.S. GAAP).
According to the Financial Accounting Standards Board (FASB), Topic 842 (ASC 842) under U.S. GAAP maintains a distinction between operating and finance leases. For leases classified as operating leases, a single lease cost is generally recognized on a straight-line basis in the income statement, unlike the treatment prescribed for lessees under IFRS 16.
Timing also plays a critical role. Companies that applied IFRS prior to 2019 generally reflect the treatment under IAS 17 in their financial statements, except in cases of early adoption of IFRS 16. Therefore, a multi-year analysis may aggregate figures prepared under divergent accounting standards.
Furthermore, the impact depends on the extent of each company’s leasing activities. A distributor that leases its warehouses and fleet may undergo a material shift in its indicators, whereas one that operates primarily with owned assets might experience a minimal effect. For this reason, these discrepancies do not necessarily offset one another within the interquartile range of comparables.
What does the OECD say about accounting consistency adjustments?
The Transfer Pricing Guidelines of the Organization for Economic Co-operation and Development (OECD) include, among the examples of comparability adjustments, those intended to eliminate differences arising from varying accounting practices between controlled and uncontrolled transactions (paragraph 3.48). They also specify that an adjustment should only be made if it is expected to increase the reliability of the analysis (paragraph 3.50). Furthermore, they caution that making adjustments may not be useful when there are material differences in accounting standards that cannot be adequately resolved (paragraph 3.52).
In practice, the analysis can neutralize the accounting effects of IFRS 16 on the tested party by reconstructing an operating result comparable to the previous treatment—which entails reversing the depreciation of the right-of-use asset and recognizing the corresponding lease expense. Alternatively, adjustments can be made to the comparable companies when sufficient and reliable information is available.
The choice depends on the information disclosed in the notes to the financial statements and the adjustment’s capacity to enhance comparability. Whichever approach is taken, it must be thoroughly explained and supported within the transfer pricing documentation, as an adjustment that cannot be reconstructed or verified will hardly withstand a tax audit.
At TPC Group, we evaluate the impact of IFRS 16 and accounting discrepancies between the tested party and the comparables in every operating margin analysis. Our objective is to ensure that the profit level indicator measures the same underlying economics on both sides of the comparison, delivering a technically defensible outcome.