Wednesday, August 25, 2010

Double-Counting Operating Leases

A prevailing theme on this site has been the idea that operating leases must be capitalized when valuing a company. But investors must be careful not to capitalize operating leases twice, which could soon become an easy mistake to make.

When a company acquires control of an asset, it can choose to buy it or lease it. If it buys the asset, but uses debt to finance the purchase, it is essentially the same thing as leasing it. Therefore, to make these two transactions identical on financial statements (since they are essentially the same thing), accounting rules require that longer leases be capitalized, so that the asset purchased and the lease payments owed are capitalized on the balance sheet, as if the asset was purchased using debt.

But some companies attempt to avoid capitalizing leases (and therefore don't have to show the future lease payments as obligations on their balance sheets) by structuring them as short-term leases, called operating leases. For this reason, many articles on this site advocate capitalizing operating leases. (To see how, see this article).

But recognizing that the capitalization of operating leases leads to more transparent financial statements, the accounting regulatory bodies are moving towards the capitalization of all leases, whether short or long. As such, investors will soon have to be careful not to capitalize operating leases when they have already been capitalized! This would lead to overstating the company's debt situation and understating the company's return on capital.

To determine whether a company already is capitalizing its operating leases, the investor will have to read the company's notes to its financial statements to determine the company's current policy (companies with different fiscal year end dates will likely have to adopt the capitalization requirements at different times).


Anonymous said...

Speaking as an iPhone user with sometimes limited bandwidth, I prefer to have the whole posts on a single page. I realize that sometimes this makes for long pages, but waiting for more page loads feels worse than scrolling a lot. It seems like ads have to be reloaded completely or something.

Saj Karsan said...

Hi Anon,

Thanks for your feedback. I'm trying this method out on advice from good sources that it is better for revenue. If the increase is not meaningful, I will switch it back.

There is a solution for you though. If you set yourself up to receive the posts through RSS (e.g. Google Reader), which can be done through your iPhone, no reloading is required and the full article is available with minimal use of bandwidth.

Paul said...


are you on facebook at all?

Saj Karsan said...

Hi Paul,

I use facebook only sparingly. However, I am on Twitter with username SajKarsan