What Are Operating Leases and How Do They Affect Earnings?

Editor’s Note: Accounting Standards Update 2016-02, which requires companies to record operating lease assets and liabilities on the balance sheet, went into effect for calendar year 2019. The adjustments/treatment of operating leases described below pertain to periods prior to 2019. For periods after 2019, we account for operating leases as explained here.

Food. Water. Shelter. The trifecta of essentials that has been grilled into anyone who has ever participated in Boy Scouts, Girl Scouts, Rangers, or any other activity involving wilderness survival training.

Companies must survive too and have these needs as well. Almost all businesses need a shelter or a space from which to perform operations, whether that is a retail store, a manufacturing plant, or an office filled with computers and Ping-Pong tables.

Due to the high costs of purchasing equipment and property, many businesses enter lease contracts to rent these items and use them in daily operations.

Investing 101: What Are Operating Leases?

An operating lease is the contract requiring a company to make regular payments in exchange for renting property or equipment.

Why Are They Important?

Operating leases are the largest and most widespread example of off-balance sheet debt. Current accounting standards only require companies to report their future lease obligations in the notes to the financial statements. Companies are not required to include this item in liabilities on the balance sheet. By not accounting for leases, one incorrectly assumes a company to be more liquid than it is.

How Should They be Treated?

Operating leases represent a liability to the company as a future cash obligation it is contractually bound to pay. The present value of future lease payments should be added to the company’s debt in order to accurately account for the amount of leverage a company uses to afford its capital expenditures.

How do Operating Leases Affect Earnings?

Operating leases generally have contracts that last over a period of years, which creates a problem for accountants.  Due to the matching principle, in which expenses are only recognized in the period in which they help to create revenue, operating lease expenses will only be expensed for that period.  A five-year contract’s cost will be spread out over those five years and deducted from revenue incrementally.

In addition, these lease expenses distort profitability through implied interest and the resultant tax shield. Future obligations similar to debt, like operating leases, have an implied interest included in their expense due to the extended time dimension of the obligation. To be as accurate as possible, company’s valuation model should not include this extra expense in its calculation of profitability. The tax shield from this implied expense should also be removed in order to determine an accurate tax rate for a business’s operations, not its financial leverage.

Are Operating Leases Bad?

Not at all. Operating leases are a great way for businesses to set up operations without investing in fixed assets.

The only problem with operating leases is that most investors do not account for the added leverage, the implied interest, and the tax benefits associated with them. This ignores important information that could drastically affect one’s investment decision.

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