Why We Capitalize Operating Leases

Summary

Operating leases can be capitalized onto the balance sheet and treated as an operating asset and liability for the calculation and equity valuation of the firm in order to understand the impact to firm value. This is done by using inputs such as the lease expense, asset life, and nominal cost of debt for the lease, with calculation using the Excel PV function.

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Operating Lease Policy Documents

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Background

Whether it is planes, trains, or automobiles, leasing assets is big business and continues to grow. Approximately 90% of U.S. companies lease equipment. Of the more than $2 trillion spent by U.S. companies in 2016 on productive assets, 10% of these assets were procured through operating lease contracts. A lease is a contract between a lessee, who makes payments for the right to use an asset, and a lessor, who owns the asset and receives payments for lending an asset. Leases come in a wide assortment of sizes and colors. In a perfect market, the cost of leasing an asset is equivalent to the cost of borrowing to purchase the asset, and creates no value, that is, the

NPV IS zero. If you owned a building, how would you determine the appropriate price for your tenants? keeping assumption of a perfect, frictionless market... what is the minimum return you would accept to assume the risk and hold a large illiquid asset? So why do companies lease Assets? For accounting purposes there are two types of leases:

1. An operating lease in which the rental expense is treated as a periodic operating expense
2. A capital or finance lease in which the asset is treated as a purchase

The accounting treatment will not apply to 90% of our clients. It is a requirement for public companies and to comply with GAAP. The purpose of this article is to understand how leases may be viewed from a financial analysis and capital budgeting perspective. Consider two identical firms where one owns property and the other leases property. Which one would you rather own? Why?

The Issue

For accounting purposes, operating leases are not owned and therefore the leased asset does not show up as an asset or a liability on the balance sheet. Operating lease details are disclosed in the footnotes. However,

Capital leases must be included on the balance sheet and have depreciation and interest expenses associated with them that run through the income statement. firms often use operating leases to keep liabilities off the balance sheet and maintain a lower debt leverage, which is sometimes an explicit requirement of existing covenants.This is yet another example where firms can engage in accounting obfuscation. If the lease classification has no direct impact on cash flow, then it should not affect the firm's value. Some sophisticated investors view this as sleight-of-hand while others see it as avoiding capital expenditure controls to preserve capital. Leases do provide value as an option when flexibility is important or tax advantages benefit shareholders. Regardless, the use of a lease (capital or operating) is fundamentally a financing decision and a liability for the company. If the firm did not need the asset, it would not expend funds whether through cash, debt, or leasing. To better understand the impact to firm value, operating leases are capitalized onto the balance sheet and treated as operating assets and liabilities for the CFROI calculation and equity valuation.

Inputs

The inputs for capitalizing leases are:

• lease expense
• asset life
• nominal cost of debt for the lease.

The cost of financing is often available in the footnotes. If a company has secured, publicly traded debt, the rate on that debt is a good proxy for the lease debt rate. For companies that do not have publicly traded debt, information on secured bank loans, or an estimate of the approximate rating of the company if it has traded debt, will work. For example, if you believe a company would be A-rated, use an A-rated corporate bond debt rate. Because we are interested in the gross amount of the capitalized lease, the life used should not be the life of the lease contract but rather the total useful life of the asset being leased. A good proxy is to assume that leased assets mimic purchased plant and equipment, and to use the gross plant life if details about the lease are unavailable.Special emphasis on the choice between leasing and purchasing as a finance decision. The goal is to invest in assets that increase the value of the firm, i.e. leasing the asset is generally more costly than owning it (not always) and not putting it on the balance sheet reduces managements ability to make good decisions.

Calculation

Capitalizing operating leases using the Excel PV function

In this example, the notation column reflect Microsoft Excel inputs for the PV function. In this example, a capitalized operating lease asset of $772 is added to the gross asset base and we add back the rental expense to net income. Actual formulas:

Source

1. Beyond Earnings