A lease is a contract where a Lessor (owner) permits a Lesse (user) to utilize an asset for a particular period. Financing and operating leases are essentially a form of financing and need to be considered as such when valuing a company.
This post will discuss the accounting treatment of financing and operating leases and their effects on valuation.
Cash is King
A business’s intrinsic value is equal to the cash flows you expect the asset to generate over its life and how uncertain you feel about these cash flows.
Cash is king when it comes to pretty much everything — including firm valuation models. Free cash flow to the firm is calculated by taking operating income minus reinvestment. We implicitly assume that operating expenses do not include financing expenses; however, this implicit assumption isn’t always correct.
Owning vs. Leasing
Firms often have a choice between buying or leasing their assets. There are two types of leases:
- Capital or financial leases
- Operating or service leases
The Financial Accounting Standards Board (FASB) states that firms must treat a lease as a capital lease if:
- Ownership transfer takes place at the end of the lease
- The lease is at least 75% of the asset’s life
- The present value of the lease payments exceeds 90% of the initial asset value
- There is a “bargain purchase” option where the lessee can purchase the asset at below expected market value
Any lease that does not meet the above is an operating lease.
From a valuation perspective, both lease obligations are debt.
Conceptually, this also makes sense. Let’s think of a capital-heavy business such as airlines. If one airline purchases their planes and another airline leases all of theirs, are they so different? I would argue that they are not. The airline requires planes to operate, and the leases are a contractual commitment that has to be met in both good and bad times. In other words, operating and capital leases are akin to borrowing money.
Accounting standards and valuation practices now agree on right-of-use assets and liabilities. Closing this off-balance sheet loophole will add approximately $2 trillion in lease liability to S&P 500 balance sheets.
Right-of-Use Assets
A right-of-use asset represents a lessee’s right to use a leased item over the lease term. The Financial Account Standards Board (“FASB”) introduced ASC 842 to increase transparency and comparability among organizations by disclosing significant information about leasing arrangements and recognizing lease assets and lease liabilities on the balance sheet.
With these changes, right-of-use assets and liabilities from capital leases are, for the most part, treated the same as operating lease right-of-use assets and liabilities; moreover, it’s a requirement to present them separately.
Calculating the Right-of-Use Asset
The initial right-of-use asset calculation for operating leases is identical to that of a financing lease — it’s essentially the capitalization process used previously.
To calculate the initial value of the ROU:
- Add the lease liability
- Plus initial direct costs
- Plus prepaid lease payments
- Less lease incentives
Accounting Examples
Let’s compare the accounting entries for both finance and operating leases. We’ll assume a lease for $3,700,000 over three years with $1,000,000, $1,200,000, $1,500,000 in payments each year. Also, assume that payments are in arrears, a 10% pre-tax cost of debt, and equal asset usage over the lease term.
When going through the examples, pay close attention to the lease and amortization expenses. Also note that the journals for financing leases have both interest and amortization expenses, and operating leases include both into one lease expense — more on this later.
Lease Commencement
Both finance and operating leases treat the creation of the lease asset and liability in the same manner, recording the asset and lease payments’ present value when the ROU is made available for use.
| ROU Asset | $3,027,799 |
| Lease Liability | $3,027,799 |
- $1,000,000 * 1.1^1 = $909,091
- $1,250,000 * 1.1^2 = $991,736
- $1,500,000 * 1.1^3 = $1,126,972
PV = $909,091 + $909,091 + $1,126,972 = $3,027,799
Financing Lease Year One Entry
For a financing lease, we have three entries. First, for the scheduled lease payment; second, to accrete the imputed interest; third, to amortize the ROU asset equally over the lease term.
| Lease Liability | 1,000,000 |
| Cash | 1,000,000 |
| Interest Expense | 302,780 |
| Lease Liability | 302,780 |
| Amortization Expense | 1,009,266 |
| ROU Amortization | 1,009,266 |
Interest Expense (imputed) is present value times cost of debt
$3,027,799 * 10% = $302,780
Amortization Expense is the present value divided by term
$3,027,799 / 3 = $1,009,266
Operating Lease Year One Entry
We have one entry for an operating lease.
| Lease Expense | 1,233,333 |
| Lease Liability | 697,220 |
| Cash | 1,000,000 |
| ROU Amortization | 930,553 |
Lease Expense is the average lease payment per year. You can think of this as containing both the principal and interest amount $3,700,000 / 3 = $1,233,333
Lease Liability is the actual payment minus the imputed interest expense $ $1,000,000 – $302,780 = $697,220
ROU Asset is the Lease Expense minus Interest Expense = $1,233,333 – $306,912 = $930,553
Financing Lease Year Two Entry
We continue to journal these transactions for a financing (capital) lease as we’ve done historically.
| Lease Liability | $1,500,000 |
| Cash | $1,500,000 |
| Interest Expense | $136,364 |
| Lease Liability | $136,364 |
| Amortization Expense | $1,009,266 |
| ROU Asset | $1,009,266 |
The debit to interest expense is the interest payment on our “loan”. It’s the present value of the remaining payments plus total interest accreted. ($3,027,799 – $1,000,000 + $302,780) * 10% = $233,058
The debit to amortization expense is reducing our asset by the “principal payment” — the lease expense minus interest expense. $1,233,333 – $233,058 = $1,000,275
Operating Lease Year Two Entry
Let’s make the year two entries for the operational lease.
| Lease Expense | $1,233,333 |
| Lease Liability | $966,942 |
| ROU Asset | $1,000,275 |
| Cash | $1,200,000 |
Financing Lease Year Three Entry
Now let’s make our final journal entries.
| Lease Liability | $1,500,000 |
| Cash | $1,500,000 |
| Interest Expense | $136,364 |
| Lease Liability | $136,364 |
| Amortization Expense | $1,009,266 |
| ROU Asset | $1,009,266 |
Operating Lease Year Three Entry
| Lease Expense | $1,233,334 |
| Lease Liability | $1,363,636 |
| ROU Asset | $1,096,970 |
| Cash | $1,500,000 |
Financing vs. Operating Lease
Let’s put everything into a table to understand what’s going on from a different perspective. With the changes, we get rid of the off-balance-sheet financing and it’s much easier to see what’s going on with our ROU assets and liabilities.
Financing Lease Table
| Lease Payment | PV of Payment | Interest Expense | Dr. Lease Liability | Amortization | Lease Expense | Tax Deduction | |
|---|---|---|---|---|---|---|---|
| 1 | $1,000,000 | $909,091 | $302,780 | $697,220 | $1,009,266 | $1,312,046 | $1,312,046 |
| 2 | $1,200,000 | $991,736 | $233,058 | $966,942 | $1,009,266 | $1,242,324 | $1,242,324 |
| 3 | $1,500,000 | $1,126,972 | $136,364 | $1,363,636 | $1,009,266 | $1,145,630 | $1,145,630 |
| 10% | $3,700,000 | $3,027,799 | $672,201 | $3,027,798 | $3,027,798 | $3,700,000 | $3,700,000 |
Operating Lease Table
| Lease Payment | PV of Payment | Interest Expense | Dr. Lease Liability | Amortization | Lease Expense | Tax Deduction | |
|---|---|---|---|---|---|---|---|
| 1 | $1,000,000 | $909,091 | $302,780 | $697,220 | $930,553 | $1,233,333 | $1,233,333 |
| 2 | $1,200,000 | $991,736 | $233,058 | $966,942 | $1,000,275 | $1,233,333 | $1,233,333 |
| 3 | $1,500,000 | $1,126,972 | $136,364 | $1,363,636 | $1,096,970 | $1,233,333 | $1,233,333 |
| 10% | $3,700,000 | $3,027,799 | $672,201 | $3,027,799 | $3,027,799 | $3,700,000 | $3,700,000 |
Leases and Valuation
From the above tables, we can see that both operating and financing leases now show up on the balance sheet with only a minor difference in the rate of tax deduction benefits. No longer will the same firm have lower debt and higher returns on capital due to how it’s represented. While this solves a significant problem and saves us a few steps, we still need to go further.
If you analyze the journal entries above, you’ll notice there is no interest expense — it’s incorporated into the operating lease expense and is deducted from operating income. This means for firms with operating leases will understate their operating income profitability.
Operating income should represent operating profitability before financing — earnings before interest and taxes (EBIT), which means we still need to adjust operating income and remove the imputed interest expense.
Operating and Financing Lease Debt Example
Let’s use Facebook as an example.
First, let’s calculate the calculate debt. Facebook’s 2019 10-K now lists lease liabilities on its balance sheet so we can include this in our interest-bearing debt calculation when determining returns on capital.
Often, you’ll need to go to the supplementary tables to get the breakdown for both operating and financing leases. As we can see below, Facebook has $11,074 million in financing and operating lease debt.
The only thing that is left is to adjust operating income. Just like our journal entries, often there is only one line item aggregating interest and amortization.
We can calculate the imputed interest cost multiple ways, but the easiest is to determine the annual amortization expense: $10,324 / 13 = $794.15
Then subtract the amortization from the operating lease cost: $1,139 – $794.15 = $344.85
And finally, remove the imputed cost from operating income and add it to interest expenses.
The Bottom Line
To valuation practitioners, leases are another form of financing. With the introduction of ASC 842, operating leases are now brought onto the balance sheet fixing one of the largest sources of off-balance-sheet financing; however, unlike financing expenses, operating leases contain both amortization and imputed interest expenses presented as a single operating expense.
This affects pre-tax operating measures and needs to be corrected when valuing companies as operating income should only contain operating expenses and not financing costs.
