Operating Leases
Many companies rely on operating leases to finance various assets. GAAP treatment of operating leases consists simply of a charge to income as rental payments are made with no record on the balance sheet. Any payments not made on a straight line basis, i.e., a fixed rent for a given period, must be either justified as reflective of usage or result in a prepaid asset or accrued liability, depending on payment structure.
GAAP treatment of leases reflects the fact that an operating lease would have no value upon the liquidation of an enterprise and would not be treated like debt in bankruptcy proceedings.
Economics of Operating Leases
Operating leases represent long-term commitments to pay for the use of an asset that is returned when the term is up. As such, they fall into a middle ground between pure rental agreements that allow you to stop paying for an asset when you are ready to surrender it, and financing arrangements, that say the asset is yours and all thatÂ’s left is for you to finish paying for it. In any case, a lease agreement requires some equity on the part of the lessee. Long-term leases presumably require more equity than short-term leases, i.e., equity amounts more consistent with ownership than with pure rentals. GAAP treatment of operating leases ignores completely the cost of the equity required to support a lease agreement.
The rent expense associated with operating lease can be looked at as having two components. The first represents reimbursement for the depreciation of the property being leased. The second represents interest expense on the funds the lessor has invested in the property.
Therefore, unlike depreciation on owned assets, rent expense contains both depreciation, which represents the decline in asset value, and interest, representing a portion of the financing cost. The part of financing not reflected in the expense is the cost of equity supporting the lease.
In lease versus buy decisions, one would compare the discounted lease payments to the equivalent amount of debt required to finance the purchase of the asset in an all debt deal. The "debt equivalent" amount would be adjusted by the residual value of the asset after the term of an equivalent lease has expired, plus other cash flow differences between the lease and purchase options.
Determining the residual value on a purchase inevitably requires judgment and can be particularly subjective for assets like buildings that don't depreciate.
The decision to acquire an asset that may either be leased or purchased should be made based on the returns provided by the use of the asset, regardless of how the asset is financed. No matter how the asset is financed, the cost of equity must be accounted for in the project's valuation and in reporting once the project is underway.
Behavioral Impact
How a lease is viewed compared to a purchase depends significantly on how the acquisition of an asset is accounted for in management reports. In terms of cash flow, leasing is often seen as the "cheaper" alternative, regardless of terms, since entry into an operating lease does not require a high up front cost.
In terms of reported income, a lease may cost more than a purchase because rent payments will generally be greater than depreciation plus interest on some portion of the purchased asset. In terms of return on capital, leasing will look better than buying because leases reflect no additional capital investment in the measure's denominator.
Each of these distortions arise from incomplete accounting for the full cost of the lease relative to the lessee's cost of capital and can seriously undermine the comparison of lease versus buy decisions.
Accounting for leases under Baseline EP comes close to resolving these problems, but also presents two problems of its own.
First, the total cost of ownership on an owned asset, i.e., its depreciation plus capital charge, will generally be higher than the rental expense on a long-term lease. That's because the capital charge on an owned asset reflects the cost of equity as well as debt whereas rent expense only includes an interest cost; it does not account for the cost of equity required to support the lease. This can encourage management to lease assets when purchases may be the better option.
Second, the interest cost in rent expense is flowing through income instead of being isolated in the capital charge. This can promote confusion between the operating benefits of a project and how it's financed. Thus, Baseline EP must be adjusted so as to account for the equity required to support a lease, and to separate the financing cost of a lease from the operating cost.
Alternative Treatments
The EP adjustment for operating leases results in depreciation only flowing through income and in the present value of the lease commitment being charged the weighted average cost of capital, which includes the cost of equity.
Option 1: Treat as GAAP Capitalized Leases
Option 2: Capitalize Using Actual Terms
