This section looks at the impact of operating versus capital leases for financial statement analysis. It gives specific guidance on how to adjust the financial statements for operating leases that should be accounted for as capital leases. Before embarking on a discussion of how to convert operating leases to capital leases, it is important to note that the FASB and IASB are close to issuing a joint standard that eliminates operating lease treatment. A draft version of this standard is expected to be ready soon, and a final version of the standard should be completed within a year or two. Once this standard becomes effective, under both US GAAP and IFRS, all leases will need to be accounted for as capital leases. This standard will eliminate one of the most important forms of off-balance-sheet financing
Impact of Operating Leases
While accounting standards allow alternative methods to best reflect differences in the economics underlying lease transactions, this discretion is too often misused by lessees who structure lease contracts so that they can use the operating lease method. This practice reduces the usefulness of financial statements. Moreover, because the proportion of capital leases to operating leases varies across companies, lease accounting affects our ability to compare different companies’ financial statements. Lessees’ incentives to structure leases as operating leases relate to the impacts of operating leases versus capital leases on both the balance sheet and the income statement. These impacts on financial statements are summarized as follows:
Impact of Operating Leases
While accounting standards allow alternative methods to best reflect differences in the economics underlying lease transactions, this discretion is too often misused by lessees who structure lease contracts so that they can use the operating lease method. This practice reduces the usefulness of financial statements. Moreover, because the proportion of capital leases to operating leases varies across companies, lease accounting affects our ability to compare different companies’ financial statements. Lessees’ incentives to structure leases as operating leases relate to the impacts of operating leases versus capital leases on both the balance sheet and the income statement. These impacts on financial statements are summarized as follows:
- Operating leases understate liabilities by keeping lease financing off the balance sheet. Not only does this conceal liabilities from the balance sheet, it also positively impacts solvency ratios (such as debt to equity) that are often used in credit analysis.
- Operating leases understate assets. This can inflate both return on investment and asset turnover ratios.
- Operating leases delay recognition of expenses in comparison to capital leases. This means operating leases overstate income in the early term of the lease but understate income late in the lease term.
- Operating leases understate current liabilities by keeping the current portion of the principal payment off the balance sheet. This inflates the current ratio and other liquidity measures.
- Operating leases include interest with the lease rental (an operating expense). Consequently, operating leases understate both operating income and interest expense. This inflates interest coverage ratios such as times interest earned.
The ability of operating leases to positively affect key ratios used in credit and profitability analysis provides a major incentive for lessees to pursue this source of offbalance- sheet financing. Lessees also believe that classifying leases as operating leases helps them meet debt covenants and improves their prospects for additional financing. Because of the impacts from lease classification on financial statements and ratios, an analyst must make adjustments to financial statements prior to analysis. Many analysts convert all operating leases to capital leases. Others are more selective. We suggest reclassifying leases when necessary and caution against indiscriminate adjustments.
Converting Operating Leases to Capital Leases
This section provides a method for converting operating leases to capital leases. The specific steps are illustrated in Exhibit 3.7 using data from Best Buy’s leasing note. It must be emphasized that while this method provides reasonable estimates, it does not precisely quantify all the effects of lease reclassification for financial statements.
Converting Operating Leases to Capital Leases
This section provides a method for converting operating leases to capital leases. The specific steps are illustrated in Exhibit 3.7 using data from Best Buy’s leasing note. It must be emphasized that while this method provides reasonable estimates, it does not precisely quantify all the effects of lease reclassification for financial statements.
The first step is to assess whether or not Best Buy’s classification of operating leases is reasonable. To do this, we must estimate the length of the remaining period beyond the five years disclosed in the notes titled “Thereafter” in the Best Buy notes of Exhibit 3.6. Specifically, we divide the reported MLP for the later years by the MLP for the last year that is separately reported. For Best Buy, we divide the total MLP for thelater years of $2.621 billion (for its 2004 operating leases) by the MLP reported in 2009, or $379 million, to arrive at 6.9 years beyond 2004. Adding this number to the five years already reported gives us an estimate of about 12 years for the remaining lease term. These results suggest a need for us to reclassify Best Buy’s operating leases as capital leases that is, its 12-year commitment for operating leases is too long to ignore. In particular, whenever the remaining lease period (commitments) is viewed as significant, we need to capitalize the operating leases.
To convert operating leases to capital leases, we need to estimate the present value of Best Buy’s operating lease liability. The process begins with an estimate of the interest rate that we will use to discount the projected lease payments. Determining the interest rate on operating leases is challenging. For companies that report both capital and operating leases, we can estimate the implicit interest rate on the capital leases and assume operating leases have a similar interest rate. The implicit rate on capital leases can be inferred by trial and error and is equal to that interest rate that equates the projected capital lease payments with the present value of the capital leases, both of which are disclosed in the leasing footnote.
Two problems can arise when inferring the interest rate from capital lease disclosures. First, it is impossible to use this method for companies that do report capital lease details. In such a case, we need to determine the yield on the company’s long-term debt or debt with a similar risk profile and then use it as a proxy for the interest rate on operating leases. A second problem can arise when the interest rates on capital and operating leases are markedly different (this can arise when operating and capital leases are entered into at different times when the interest rates are different). In this scenario, we need to adjust the capital lease interest rate to better reflect the interest rate on operating leases.
Best Buy’s bond rating is BBB, which results in an effective 10-year borrowing cost of about 5.8% in 2005. For the example that follows, we use 5.8% as a discount rate to determine the present value of the projected operating lease payments. This analysis is presented in Exhibit 3.7. Lease payments for 2005–2009 are provided in the leasing footnote as required. The estimated payments after 2009 are assumed equal to the 2009 payment and continue for the next seven years with a final lease payment of $347 million in the 12th year (2016). Discounting these projected lease payments at 5.8% yields a present value of $3.321 billion. This is the amount that should be added to Best Buy’s reported liabilities.
The next step in our analysis is to compute the value of the operating lease asset. Recall that the asset value of a capital lease is always lower than its corresponding liability, but how much lower is difficult to estimate because it depends on the length of the lease term, the economic life of the asset, and the lessee’s depreciation policy. Consequently, for analysis of operating leases, we assume that the leased asset value is equal to the estimated liability. For Best Buy, this means both the leased asset and lease liability are estimated at $3.321 billion for 2004. We also can split the operating lease liability into its current and noncurrent components of $261 million and $3.06 billion, respectively. Once we determine the operating lease liability and asset, we then must estimate the impact of lease reclassification on reported income.
To convert operating leases to capital leases, we need to estimate the present value of Best Buy’s operating lease liability. The process begins with an estimate of the interest rate that we will use to discount the projected lease payments. Determining the interest rate on operating leases is challenging. For companies that report both capital and operating leases, we can estimate the implicit interest rate on the capital leases and assume operating leases have a similar interest rate. The implicit rate on capital leases can be inferred by trial and error and is equal to that interest rate that equates the projected capital lease payments with the present value of the capital leases, both of which are disclosed in the leasing footnote.
Two problems can arise when inferring the interest rate from capital lease disclosures. First, it is impossible to use this method for companies that do report capital lease details. In such a case, we need to determine the yield on the company’s long-term debt or debt with a similar risk profile and then use it as a proxy for the interest rate on operating leases. A second problem can arise when the interest rates on capital and operating leases are markedly different (this can arise when operating and capital leases are entered into at different times when the interest rates are different). In this scenario, we need to adjust the capital lease interest rate to better reflect the interest rate on operating leases.
Best Buy’s bond rating is BBB, which results in an effective 10-year borrowing cost of about 5.8% in 2005. For the example that follows, we use 5.8% as a discount rate to determine the present value of the projected operating lease payments. This analysis is presented in Exhibit 3.7. Lease payments for 2005–2009 are provided in the leasing footnote as required. The estimated payments after 2009 are assumed equal to the 2009 payment and continue for the next seven years with a final lease payment of $347 million in the 12th year (2016). Discounting these projected lease payments at 5.8% yields a present value of $3.321 billion. This is the amount that should be added to Best Buy’s reported liabilities.
The next step in our analysis is to compute the value of the operating lease asset. Recall that the asset value of a capital lease is always lower than its corresponding liability, but how much lower is difficult to estimate because it depends on the length of the lease term, the economic life of the asset, and the lessee’s depreciation policy. Consequently, for analysis of operating leases, we assume that the leased asset value is equal to the estimated liability. For Best Buy, this means both the leased asset and lease liability are estimated at $3.321 billion for 2004. We also can split the operating lease liability into its current and noncurrent components of $261 million and $3.06 billion, respectively. Once we determine the operating lease liability and asset, we then must estimate the impact of lease reclassification on reported income.
There are two expenses relating to capitalized leases interest and depreciation. Interest expense is determined by applying the interest rate to the present value of the lease (the lease liability). For Best Buy, this is estimated at $193 million for 2005, or 5.8% of $3.321 billion (see Exhibit 3.7). Depreciation expense is determined by dividing the value of the leasehold asset by the remaining lease term. Assuming no residual value, depreciation of the $3.321 billion in leased assets on a straight-line basis over the 12-year remaining lease term yields an annual depreciation expense of $277 million. Total expense, then, is estimated at Once we determine the operating lease liability and asset, we then must estimate the impact of lease reclassification on reported income. There are two expenses relating to capitalized leases interest and depreciation. Interest expense is determined by applying the interest rate to the present value of the lease (the lease liability). For Best Buy, this is estimated at $193 million for 2005, or 5.8% of $3.321 billion . Depreciation expense is determined by dividing the value of the leasehold asset by the remaining lease term. Assuming no residual value, depreciation of the $3.321 billion in leased assets on a straight-line basis over the 12-year remaining lease term yields an annual depreciation expense of $277 million. Total expense, then, is estimated at
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