Operating Lease Obligations: The Hidden Debt in Shariah Screening

In January 2019, an accounting standards change quietly rewrote Shariah compliance for dozens of companies. IFRS 16 and its US counterpart ASC 842 took effect, requiring companies to put operating lease obligations on their balance sheets as liabilities. Before that date, those obligations lived in the footnotes, visible but not counted.

For retail chains, airlines, and hotel companies, the change was enormous. Balance sheet debt doubled or tripled overnight for some companies, not because they had borrowed more, but because accounting rules caught up with economic reality.

The question for Shariah screening: do these newly visible lease obligations count as debt for ratio purposes?

The answer, after about two years of scholarly discussion, became mostly yes. And that answer changed the compliance status of a lot of stocks.

What changed in 2019

Before IFRS 16, companies had two kinds of leases: finance leases (treated as debt on balance sheet) and operating leases (not on balance sheet). A company renting 500 store locations under multi-year agreements would disclose those commitments in a footnote table showing future minimum lease payments over 1, 5, and 10+ year horizons. The balance sheet itself showed nothing.

After IFRS 16, every lease over 12 months gets recognized as:
- A right-of-use asset on the asset side
- A lease liability on the liability side

The lease liability is the present value of future lease payments discounted at an appropriate rate. For a company with hundreds of leased locations, the liability can be tens of billions of dollars or euros.

The same change happened under US GAAP as ASC 842. Private companies and smaller entities had slightly delayed adoption but the principle was the same.

Why Shariah scholars had to weigh in

As soon as the lease liabilities hit balance sheets, debt ratios started looking different. A company that had previously shown 5 billion in "debt" suddenly showed 12 billion in "debt plus lease liabilities." The debt-to-market-cap ratio jumped correspondingly.

The question: is a lease liability the same kind of "interest-bearing debt" that the Shariah screen was designed to catch?

The argument for including leases:
- They're financial commitments accruing interest (the "imputed interest" in the lease payment)
- They represent debt-like obligations that constrain the company economically
- Excluding them would let companies game the screen by structuring financing as long-term leases instead of loans
- AAOIFI and similar bodies had historically been concerned with the economic substance, not just the legal form

The argument for excluding leases:
- Leases are payments for the use of a physical asset (a store, an aircraft, a warehouse)
- The "interest component" is embedded in the economic rent, not a separate financing cost
- Lessees pay lessors, not lenders
- Historically, operating leases were treated as operating expenses, not debt
- Inclusion dramatically changes compliance results for many companies without any underlying change in their business

Where AAOIFI landed

AAOIFI has issued guidance (informally and in updated commentary) that operating lease liabilities should generally be treated like debt for screening purposes because their economic substance resembles financing. The organization's rationale: a lease over an extended period locks the lessee into payment streams with built-in interest-equivalent components, which is functionally similar to borrowing and repaying a loan.

This position is broadly accepted by the stricter end of the spectrum. AAOIFI-aligned funds started including lease obligations in their debt calculations starting around 2020 and 2021.

Where DJIM and S&P Shariah landed

DJIM and S&P Shariah, which use market cap denominators, also generally include lease liabilities in the debt numerator as a matter of consistency with the accounting standards. Their reasoning: if the auditors are classifying these as liabilities, the Shariah screen should treat them as liabilities too.

There's some inconsistency in implementation. Some index providers use "total financial debt" that excludes leases. Others use "total liabilities excluding trade payables" which includes leases. Fund managers following these indices inherit whatever methodology the index provider uses.

The airlines example

Airlines are the cleanest case study. Airlines lease enormous numbers of aircraft, often through operating leases, to keep their balance sheets flexible and avoid the capital commitments of owning planes outright. Before IFRS 16, airlines looked relatively debt-light. After IFRS 16, they look much more leveraged.

Consider a major airline that might report the following (hypothetical but representative):

Pre-IFRS 16:
- Reported debt: 12 billion
- Market cap: 18 billion
- Debt ratio: 66%. Fail.

Airlines were often fail stocks even before IFRS 16 because aircraft financing is huge. But operating lease inclusion made it even worse:

Post-IFRS 16:
- Reported debt: 12 billion
- Lease liabilities: 8 billion
- Total: 20 billion
- Market cap: 18 billion
- Debt ratio: 111%. Fail badly.

Airlines have always been non-compliant under Shariah screening due to debt levels and the inclusion of alcohol service in flight operations. The lease accounting change just made the fail more emphatic.

The retailer example

Retailers are the more interesting case because many were previously compliant and some became questionable after IFRS 16. Consider a large retail chain (hypothetical):

Pre-IFRS 16:
- Debt: 3 billion
- Market cap: 25 billion
- Debt ratio: 12%. Pass comfortably.

Post-IFRS 16, the same company added 6 billion in lease liabilities from leased store locations:
- Debt: 3 + 6 = 9 billion
- Market cap: 25 billion
- Debt ratio: 36%. Fail.

This is not hypothetical for some chains. A handful of retailers that had been Shariah-compliant for years suddenly failed their debt screens in 2019-2020 after the accounting change. Some scholars argued for a transitional period where lease liabilities would be excluded for a few quarters while the industry adjusted. Others argued for immediate inclusion because the underlying economic reality hadn't changed.

The practical compromise: most funds began including lease liabilities but with a grace period during which flagged stocks could stay in the portfolio for a few quarters while management explored options.

Apple's operating leases

Apple (AAPL) has operating lease obligations primarily related to corporate offices, retail stores, data centers, and equipment. Approximate figures:

• Apple's lease liabilities: approximately 11 billion
• Apple's other interest-bearing debt: approximately 100 billion
• Total (including leases): approximately 111 billion
• Apple's market cap: approximately 3.5 trillion

Debt ratio including leases: 3.17%. Still very comfortable. The lease inclusion adds 0.3 percentage points to Apple's debt ratio, which is noticeable but not decisive.

This is where scale matters. Apple's business is so large that even enormous lease obligations are small relative to market cap. The ratio barely moves. For smaller companies, a comparable lease book relative to market cap could be fatal.

Microsoft's lease book

Microsoft (MSFT) has operating lease obligations from data centers, offices, and equipment. Approximate:

• Lease liabilities: approximately 20 billion
• Other debt: approximately 60 billion
• Total: 80 billion
• Market cap: approximately 3.2 trillion

Debt ratio including leases: 2.5%. Same story. Passing easily. The data center leases are actually significant in absolute terms but minuscule relative to Microsoft's market cap.

The Toyota situation

Toyota (7203.T) already has enormous debt because of Toyota Financial Services. Adding lease obligations barely changes the picture.

• Consolidated debt: approximately 29 trillion yen
• Operating lease liabilities: approximately 500 billion yen
• Total: approximately 29.5 trillion yen
• Market cap: approximately 40 trillion yen
• Total assets: approximately 74 trillion yen

Whether you include leases or not, Toyota fails the debt ratio under total assets methodologies. The lease inclusion makes it slightly worse but doesn't change the outcome.

The Nestlé picture

Nestlé (NESN.SW) has operating lease obligations from offices, manufacturing facilities, and distribution centers. Approximate:

• Lease liabilities: approximately 4 billion CHF
• Other debt: approximately 55 billion CHF
• Total: approximately 59 billion CHF
• Total assets: approximately 135 billion CHF
• Market cap: approximately 260 billion CHF

Debt ratio under total assets (post-lease): 59 / 135 = 43.7%. Still failing.
Debt ratio under market cap (post-lease): 59 / 260 = 22.7%. Still passing.

Nestlé's situation doesn't change materially with lease inclusion because the lease book is small relative to the other debt. The fundamental tension for Nestlé is between total-assets and market-cap methodologies, not between lease-inclusive and lease-exclusive calculations.

The retailers who became marginal

A few retail chains that were near the threshold became marginal or failed after lease inclusion. I'll describe the pattern without naming specific small-caps that might have since recovered.

Retail chains with 200+ leased stores often saw their debt ratios jump by 10-20 percentage points when lease liabilities were included. Companies that had been at 20% debt ratios suddenly showed 35-40% ratios. Under the 33% threshold, several slipped into non-compliance.

The response varied:
- Some chains renegotiated leases to shorter terms to reduce the present value
- Some chains bought properties they had been leasing, shifting the obligation from lease liability to owned asset with associated debt (which often didn't improve the ratio but at least made the balance sheet more honest)
- Some chains accepted the non-compliance and waited for the 24-36 month averaging windows to smooth the impact

FaithScreener's treatment

We include operating lease liabilities in the debt numerator by default. This reflects the majority scholarly position and matches how most major index providers calculate their ratios. You can see the breakdown on each stock detail page: "interest-bearing debt" shows both the traditional borrowings and the lease-driven additions.

If you want to see the stock under the minority methodology (leases excluded), we provide a toggle. This lets you see which stocks are sensitive to the lease inclusion question and which aren't.

The broader lesson

Accounting changes can rewrite Shariah compliance without anything actually changing about the underlying business. A retailer's stores didn't become more or less leveraged on January 1, 2019. The accounting standards just started acknowledging what had always been true.

This is a reminder that Shariah screening is tied to reported financial statements, which are governed by accounting rules set by secular bodies (the IASB, FASB, and various national standard-setters). When those rules change, compliance results change.

It's not a perfect system. But it's a defensible one because the alternative, having Shariah scholars set their own accounting rules, would create enormous complexity and inconsistency. The current approach of piggy-backing on IFRS and GAAP at least gives everyone a common reference point.

Just remember: if a stock's Shariah status flipped in 2019 or 2020, the cause was probably lease accounting, not anything the company did wrong.