http://TheValueatRisk.blogspot.

com 
November 12, 2009 
 

Analyzing Leases On and Off the Balance Sheet 
 
n 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
http://TheValueatRisk.blogspot.com 
November 12, 2009 
 
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
http://TheValueatRisk.blogspot.com 
November 12, 2009 
 
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.

*no positions

Copyright 2009 ‐ The Value at Risk  

For additional analysis of financial markets and politics, or to view information about the author, please visit 
http://TheValueatRisk.blogspot.com 

The content contained within this newsletter, as well as The Value at Risk website, is provided as general information only and 
should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any 
security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site 
are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The 
author(s) may or may not have a position in any security referenced herein. Any action that you take as a result of information 
or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment 
decisions.