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Operating Lease

An agreement to use and operate an asset without ownership

What is an Operating Lease?

An operating lease is an agreement to use and operate an asset without ownership. Common assets that are leased include real estate, automobiles, aircraft, or heavy equipment. By renting and not owning, operating leases enable companies to keep from recording an asset on their balance sheets by treating them as operating expenses.

 

Operating Lease Sign

 

Operating Lease vs. Capital Lease

An operating lease is different from a capital lease and must be treated under different guidelines. Under an operating lease, the lessee enjoys no risk of ownership, but cannot claim tax benefits.

For a lease to qualify as a capital lease, it must meet any of the following criteria as outlined by GAAP:

  • The lease term is greater than or equal to 75% of the asset’s estimated useful life
  • The present value of the lease payments is greater than or equal to 90% of the fair value of the asset
  • Ownership of the asset may be transferred to the lessee at the end of the lease
  • The lease contains a bargain purchase option to buy the equipment below market value

Additionally, under IFRS, there are a few more criteria that a lease can meet to qualify as a capital lease:

  • The leased assets are specialized to the point that only the lessee can utilize these assets without major changes being made to them

Under a capital lease, the lessee is considered an owner and can claim depreciation and interest expense for tax purposes. However, the leased asset and lease payments are shown on the balance sheet.

 

Capitalizing Leases

If a lease does not pass any of the above criteria, it is considered an operating lease. Assets acquired under operating leases do not need to be reported on the balance sheet. Likewise, operating leases do not need to be reported as a liability on the balance sheet, as they are not treated as debt. The firm does not record any depreciation for assets acquired under operating leases.

However, if a lease does pass any of the above criteria, it is instead considered as a capital lease. A capital lease is treated differently from an operating lease. Instead of being treated as an operating expense, a capital lease is considered a financing expense. Therefore, we need to adjust the lease expense, depreciation expense, and interest expense numbers to account for this shift.

This will have an effect on operating income, which will always increase when these expenses are recategorized. However, it will not have any net change in net income, as the change in numbers will balance out.

There are two methods to capitalize leases: the full adjustment method and the approximation method.

 

#1: The Full Adjustment Method

Step 1: Collect input data

Find the operating lease expenses, operating income, reported debt, cost of debt, and reported interest expenses.

Cost of debt can be found using the firm’s bond rating. If there is no existing bond rating, a “synthetic” bond rating can be calculated using the firm’s interest coverage ratio. Using the interest coverage ratio, compare it to this table created by New York University, Stern Business School professor Aswath Damodaran.

The remaining input data can be found in the company’s financial statements or the notes to the financial statements.

 

Operating Lease - Full Adjustment Method Step 1

 

Step 2: Calculate the Present Value of Operating Lease Commitments

By capitalizing an operating lease, a financial analyst is essentially treating the lease as debt. Both the lease and the asset acquired under the lease will appear on the balance sheet. The firm must adjust depreciation expenses to account for the asset and interest expenses to account for the debt.

To do this, you must find the debt value of the operating leases. find the present value of future operating lease expenses by discounting each year’s expense by the cost of debt. The annuity method can be used if lease expenses are provided and remain constant over a timeframe of multiple years (e.g. years 6-10).

 

Operating Lease - Full Adjustment Method Step 2

 

Step 3: Calculate Depreciation Expenses, Imputed Interest, and Adjusted Interest Expenses

We need to calculate depreciation and adjust interest expenses. To calculate depreciation, we use the debt value of leases and employ the straight-line method of depreciation.

To adjust interest expenses, we begin with a simplifying assumption: operating lease expense is equal to the sum of imputed interest expense and depreciation. With this assumption, we can use our newly calculated depreciation value to find imputed interest expense on operating lease. Take the difference between the current year operating lease expense and our calculated depreciation value to find the imputed interest on the operating lease.

Finally, add the imputed interest expense on operating lease to interest expenses to find adjusted interest.

 

Operating Lease - Full Adjustment Method Step 3

 

Step 4: Adjust Financials

First, we need to adjust operating income. Begin with the reported operating income (EBIT). Then, add the current year’s operating lease expense and subtract the depreciation on the leased asset to arrive at adjusted operating income.

 

Operating Lease - Full Adjustment Method Step 4 - Operating Income

 

Even though operating income has changed, there should not be a change in net income due to our simplifying assumption. Below are the calculations illustrating this:

 

Operating Lease - Full Adjustment Method Step 4 - Net Income

 

Finally, to adjust debt, take the reported value of debt (book value of debt) and add the debt value of the leases.

 

Operating Lease - Full Adjustment Method Step 4 - Debt

 

#2: The Approximation Method

Step 1: Collect input data

Like the full adjustment method, we will need to collect the same input data.

 

Step 2: Calculate the Present Value of Operating Lease Commitments

The second step for the approximation method is identical to the full adjustment method as well. We need to calculate the present value of operating lease commitments to arrive at the debt value of the lease.

 

Step 3: Calculate Imputed Interest, Adjusted Interest Expenses, and Depreciation Expenses

Unlike the full adjustment method, the approximation method begins with calculating imputed interest. This is simpler because there is no need to worry about depreciation methods and guidelines. To calculate the imputed interest on the operating lease, use multiply the debt value of the lease by the cost of debt.

We can use this imputed interest value to adjust the interest expense. We do this by adding the imputed interest to interest expense.

Finally using our simplifying assumption from earlier, take the difference between the current year’s operating lease expense and the imputed interest to find depreciation expenses.

 

Operating Lease - Approximation Method Step 3

 

Step 4: Adjust Financials

Adjusting financials with the approximation method is slightly different from the full adjustment method. Begin by adjusting operating income. Take the reported operating income (EBIT) for the year and add the calculated imputed interest on operating lease to obtain the adjusted operating income.

 

Operating Lease - Approximation Method Step 4 - Operating Income

 

Like with the full adjustment method, though operating income has changed, net income should not. Below are the calculations to illustrate this effect:

 

Operating Lease - Approximation Method Step 4 - Net Income

 

Finally, adjusting debt is the same as the full adjustment method. Add the debt value of the leases to the reported debt value.

 

Operating Lease - Approximation Method Step 4 - Debt

 

Impact on Valuation

There are two effects on free cash flow to the firm (FCFF) when we treat operating lease expenses as financing expenses by capitalizing them:

  1. FCFF will increase because the imputed interest expense on the capitalized operating leases is added back to the operating income (EBIT).
  2. FCFF will decrease if the present value of operating leases increases (and vice versa) due to the net change in capital expenditures. This occurs because we must treat operating leases like capital expenditures if capitalize them.

Furthermore, the weighted average cost of capital (WACC) will decrease as the debt ratio increases, which has a positive impact on the value of the firm. It is important to note that the increase in firm value derives solely from the value of debt, and not the value of equity. If the debt ratio stays stable, and the operating leases are fairly valued, treating operating leases as debt should have a neutral effect on the value of equity.

 

Other Resources

We hope you’ve enjoyed reading our guide to operating leases. To learn more, see the following free resources.

  • Lease Classifications
  • Lease Accounting
  • Prepaid Lease
  • Projecting Balance Sheet Items

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