II. Misclassified Financial Expenditures

Firms often choose to lease long-term assets rather than buy them. A long-term lease creates the same kind of obligations as debt, and it must be viewed in a similar light. If a firm is allowed to lease a significant portion of its assets and keep it off its balance sheet, a perusal of the liabilities will give a very misleading view of the company's financial strength and capital invested. In this section, we will consider the distinction drawn between capital and operating leases by accountants, and how the treatment of the latter can result in skewed estimates of return on capital.

The Accounting Treatment of Leases

There are two ways of accounting for leases. In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not show up in the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.

Since firms prefer to keep leases off the books, they have a strong incentive to report all leases as operating leases. Consequently the Financial Accounting Standards Board has ruled that a lease should be treated as a capital lease if it meets any one of the following four conditions:

(a) The lease life exceeds 75% of the life of the asset.

(b) There is a transfer of ownership to the lessee at the end of the lease term.

(c) There is an option to purchase the asset at a "bargain price" at the end of the lease term.

(d) The present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.

The lessor uses the same criteria for determining whether the lease is a capital or operating lease and accounts for it accordingly. If it is a capital lease, the lessor records the present value of future cash flows as revenue and recognizes the expenses associated with generating these revenues. The lease receivable is also shown as an asset on the balance sheet and the interest revenue is recognized over the term of the lease as paid. From a tax standpoint, the lessor can claim the tax benefits of the leased asset only if it is an operating lease, though the revenue code uses slightly different criteria17 for determining whether the lease is an operating lease.

Converting Operating Leases into Debt

While accountants and the tax authorities may differentiate between capital and operating leases, we see no reason for the differentiation in corporate finance and valuation. Operating lease commitments look very much like debt commitments insofar as firms as contractually obligated to make them. It is true that they may offer more flexibility and escape clauses than conventional debt, since firms can sometimes selectively abandon leases on properties that are not financially viable without exposing themselves to default risk. In that sense, they may be closer to unsecured debt than secured debt, but they should still be treated as debt.

17 The requirements for an operating lease in the revenue code are as follows - (a) the property can be used by someone other than the lessee at the end of the lease term, (b) the lessee cannot buy the asset using a bargain purchase option, (c) the lessor has at least 20% of its capital at risk, (d) the lessor has a positive cash flow from the lease independent of tax benefits and (e) the lessee does not have an investment in the lease.

See Technical Indicators