Analyzing Leases On and Off the Balance Sheet

In the midst of the criticism that's been leveled towards financial innovation of all shapes and sizes, one form of financial instrument in particular has managed to travel under the radar: leases. Although leases have never been accused of wreaking financial destruction, they do serve as a convenient means of off-balance sheet financing.

The first thing to know about leases as they pertain to financial statements is that there are two main categories: Operating Leases and Capital Leases. The closer a lease is to an actual purchase agreement, the more likely it is that the lease should be classified as Capital. There are however four conditions which, if any are met, automatically render the agreement a Capital Lease. They are:

1. The lease agreement contains a provision whereby, at the end of the lease term, title to the leased asset is transferred from the lessor to the lessee.
2. The lease agreement provides the lessee an option to purchase the leased asset at bargain terms (like $1 for instance)
3. The term of the lease agreement constitutes a period of time which is greater than or equal to 75% of the leased assets useful/economic life.
4. The present value of all scheduled lease payments is greater than or equal to 90% of the fair market value of the leased asset.

At this point, you're probably questioning why it really matters whether accountants refer to the lease as Operating or Capital. Simply put, a Capital Lease must come onto the balance sheet via a debit to Leased Asset and a credit to Lease Liability. The amount recorded on the balance sheet is the present value of all future lease payments. Operating Leases on the other hand are not capitalized, and only appear to external stakeholders in the form of footnote disclosures in regulatory filings. The accounting for Operating Leases is relatively straightforward however; lease payments simply flow to the income statement and are recorded as Rent Expense. Capital Leases though, have interest and principle components that must be amortized over the lease term just like a debt instrument. Below is an amortization schedule for an asset of FMV $70,000 , a lease term of 6 years and $15,000 annual payments. Using the Internal Rate of Return (IRR) function on Excel, I'm able to discover that the lease contains an implied interest rate of 7.69%.
As I mentioned above, the leased asset must be depreciated over time. Below is the depreciation table for the same example.
The table above brings me to the next point: expenses under a Capital Lease are front-loaded, whereas an Operating Lease maintains consistency. In years 1-6 in the above example, the total expense for an Operating Lease would be $15,000/year. Keep in mind that my prior point isn't applicable to the cash flow statement; I'm only discussing income statement implications. From a cash flow standpoint, the interest portion of Capital Leases is classified as a Financing Activity, and the principal re-payment is considered an Operating Activity. Under Operating Leases, the entire rent expense is classified as an Operating Activity. In this sense, Capital Leases will result in higher cash flow from operations than a similar Operating Lease.

The final nuance that's important to grasp is that Operating Leases can distort certain leverage related financial ratios such as debt to equity and return on assets (ROA). The distorting effect can range from very minimal to materially drastic, especially in the case of businesses like airlines who lease the majority of their assets. Nevertheless, leases should be reason alone to spend some time examining the footnote disclosures found in your subject firm's financial statements.

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