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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 presentation.)

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).

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to my feed.