I Hate Operating Leases
Part of the process of studying for CFA level II involves rehashing some of the basics from round one. This works out great, with my work today bringing me straight to Study Session 10, section C: Leases and Off-Balance-Sheet Debt.
First the textbook lesson, second my commentary....
There are 2 different types of leases, capital and operating.
Capital leases are treated as sales (purchases) by the lessor (lessee). The asset is carried on the lessee's books and the capital lease is rightfully treated a debt on the balance sheet. Furthermore, the lessee makes interest and principal payments to the lessor which accordingly records incoming interest and principal payments. The payment of principal is key because when it comes to the cash flow statement, a principal payment is a financing CF, not operating. The effect is to make capital leases favorable to operating leases, from an operating cash flow and free cash flow perspective.
Operating leases on the other hand result in NO balance sheet liability, nor a corresponding asset. The periodic lease payment is considered a rent expense and thus has the effect of depressing operating margins (whereas capital leases, with interest payments, have no negative effect on operating expenses). Just because no on-balance liability is recorded, this doesn't mean that a real liability does not exist. In the footnotes (generally only found annually in 10ks), the liabilities are recorded in the form of a schedule of future required minimum lease payments (MLPs). Actual prior year rent expense is also provided; actual rent expense generally is always larger than the MLP schedule would suggest.
Now, from an accounting perspective, firms would generally prefer not to record a liability on the balance sheet. For this reason some crafty tinkering of lease contracts occur so as to ensure a lease is classified as operating rather than capital. You may ask, "what are the criteria for classifying a lease as capital?" Well, I am glad you asked!
Four criteria (thanks to SFAS 13):
The basic idea is that if looks like a purchase, smells like a purchase, then account for it like a purchase.....and put that debt on the balance sheet!
Time for Commentary:
But wait a minute, what about the fact that capital leases result in higher cash flows than operating leases? Do investors employing a discounted cash flow based valuation not use these very cash flows to value a business? Yes, yes they do. However, it seems that companies are more concerned with making their leverage ratios pretty than they are worried about cash flow. Its the accounting stupid, not the cash flows...
In my last job in the treasury of the ole fortune 500 company, I completed several lease versus buy calculations for the treasurer and in each case the purchase decision made the most economic sense, yet in each case we went with the lease. Our cost of capital through our credit facility was soo cheap that not a single third party leasing company could offer us a cheaper implied interest rate. Used to drive me crazy...the damn savings to be had were multiples over my measly salary!! Part of the problem came right down to bureaucracy. The division for which the equipment was needed had fixed operating budgets. In order to authorize an adjustment to the budget for the clearance of a purchase, way too many people had to sign-off...I think the CFO even needed to touch it.
Anyways, today at work I was analyzing a few companies that all had substantial operating leases....come on folks....we know what game you are playing!! I capitalized all the leases and threw the assets back on the balance sheet. One of the unnamed companies likes to also include proceeds from sale-leaseback in its free cash flow calculation....puuuuulease.
An operating lease is just another option of several financing alternatives for a company...albeit often times the most economically expensive option...but a favored option nonetheless.
additional source:
Aswath Damodaran is the man
Anything to add??
Mr. Risky Returns
First the textbook lesson, second my commentary....
There are 2 different types of leases, capital and operating.
Capital leases are treated as sales (purchases) by the lessor (lessee). The asset is carried on the lessee's books and the capital lease is rightfully treated a debt on the balance sheet. Furthermore, the lessee makes interest and principal payments to the lessor which accordingly records incoming interest and principal payments. The payment of principal is key because when it comes to the cash flow statement, a principal payment is a financing CF, not operating. The effect is to make capital leases favorable to operating leases, from an operating cash flow and free cash flow perspective.
Operating leases on the other hand result in NO balance sheet liability, nor a corresponding asset. The periodic lease payment is considered a rent expense and thus has the effect of depressing operating margins (whereas capital leases, with interest payments, have no negative effect on operating expenses). Just because no on-balance liability is recorded, this doesn't mean that a real liability does not exist. In the footnotes (generally only found annually in 10ks), the liabilities are recorded in the form of a schedule of future required minimum lease payments (MLPs). Actual prior year rent expense is also provided; actual rent expense generally is always larger than the MLP schedule would suggest.
Now, from an accounting perspective, firms would generally prefer not to record a liability on the balance sheet. For this reason some crafty tinkering of lease contracts occur so as to ensure a lease is classified as operating rather than capital. You may ask, "what are the criteria for classifying a lease as capital?" Well, I am glad you asked!
Four criteria (thanks to SFAS 13):
- The lease transfers ownership of the property to the lease at the end of the lease term.
- The lease contains a bargain purchase option.
- The lease term is equal to 75% or more of the estimated economic life of the leased property (not applicable to land or when the lease term begins within the final 25% of the economic life of the asset).
- The present value of the minimum lease payments (MLPs) equals or exceeds 90% of the fair value of leased property to the lessor.
The basic idea is that if looks like a purchase, smells like a purchase, then account for it like a purchase.....and put that debt on the balance sheet!
Time for Commentary:
But wait a minute, what about the fact that capital leases result in higher cash flows than operating leases? Do investors employing a discounted cash flow based valuation not use these very cash flows to value a business? Yes, yes they do. However, it seems that companies are more concerned with making their leverage ratios pretty than they are worried about cash flow. Its the accounting stupid, not the cash flows...
In my last job in the treasury of the ole fortune 500 company, I completed several lease versus buy calculations for the treasurer and in each case the purchase decision made the most economic sense, yet in each case we went with the lease. Our cost of capital through our credit facility was soo cheap that not a single third party leasing company could offer us a cheaper implied interest rate. Used to drive me crazy...the damn savings to be had were multiples over my measly salary!! Part of the problem came right down to bureaucracy. The division for which the equipment was needed had fixed operating budgets. In order to authorize an adjustment to the budget for the clearance of a purchase, way too many people had to sign-off...I think the CFO even needed to touch it.
Anyways, today at work I was analyzing a few companies that all had substantial operating leases....come on folks....we know what game you are playing!! I capitalized all the leases and threw the assets back on the balance sheet. One of the unnamed companies likes to also include proceeds from sale-leaseback in its free cash flow calculation....puuuuulease.
An operating lease is just another option of several financing alternatives for a company...albeit often times the most economically expensive option...but a favored option nonetheless.
additional source:
Aswath Damodaran is the man
Anything to add??
Mr. Risky Returns
It is simply matchless :)
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5/28/2011 7:37 AM