Should operating leases be presented as liabilities on balance sheets?

[tooskinneejs]

U.S. accounting standard setters are considering a change in GAAP that would require operating leases to be presented as liabilities on the balance sheet (with an offsetting asset titled “right to use leased item”).  Question: Would this change in accounting principles be useful/preferable to you as an investor?

[Mephistopheles]

I'm a fairly new investor, and I've always had a question regarding this. Why should operating leases be put on the balance sheet, or considered as liabilities even if not on the balance sheet? Why do they just not count as regular expenses, in the income statement?

[Olmsted]

Why do they just not count as regular expenses, in the income statement?

 

Mephistopheles, I think the key is that once a lease is entered into, it is non-discretionary.  A firm can stop buying inputs into a manufacturing process if it wishes to slow manufacturing, the firm can lay off excess employees.  But if it decides to stop paying its leases, bad things can happen.  Ch11-type bad things.  Not a whole lot different than if it defaulted on some bonds.  Or so the thinking goes.

 

The question for me becomes, if we are going to capitalize leases, where to stop?  Long-term purchasing contracts?  Contracts for multi-year talent (athletes, radio personalities, etc.)?

[Mephistopheles]

Why do they just not count as regular expenses, in the income statement?

 

Mephistopheles, I think the key is that once a lease is entered into, it is non-discretionary.  A firm can stop buying inputs into a manufacturing process if it wishes to slow manufacturing, the firm can lay off excess employees.  But if it decides to stop paying its leases, bad things can happen.  Ch11-type bad things.  Not a whole lot different than if it defaulted on some bonds.  Or so the thinking goes.

 

 

Ah, that's what I assumed, thanks!

[WarrenWatsa]

In substance, an operating lease is a debt and thereby a liability.

 

 

I would support an initiative to put operating leases on the B/S as opposed to income statement.

[Parsad]

U.S. accounting standard setters are considering a change in GAAP that would require operating leases to be presented as liabilities on the balance sheet (with an offsetting asset titled “right to use leased item”).  Question: Would this change in accounting principles be useful/preferable to you as an investor?

 

No.  Leases are already on the balance sheet, and they are a liability.  If the leasee does not sublease the property when not in use, then it is a liability, so there should be no offsetting asset unless it is under a sublease agreement...if it is not in use, then how can it be considered an asset?  It's plainly understandable the way it is, and by putting an offsetting asset only gives the impression that liabilities are less than in actuality.  Cheers! 

[WarrenWatsa]

Parsad,

 

 

To my knowledge, future amounts owing on an operating lease agreement are not shown on the B/S (unlike on a capital lease agreement).  Operating leases  are not presented as liabilities except for the portion that has been expensed and remains unpaid.

[Parsad]

Sorry Watsa, I thought they were talking about capital leases.  Cheers!

[txlaw]

Question: Will the right to use asset always match up one for one with the operating lease liability? 

 

Like, say, you have long term real estate leases where you are paying below market rent, and then you sublease the real estate, earning a spread.  Do you capitalize the right to use asset such that the asset is greater than the liability?

[pabraifan]

Question: Will the right to use asset always match up one for one with the operating lease liability? 

 

Like, say, you have long term real estate leases where you are paying below market rent, and then you sublease the real estate, earning a spread.  Do you capitalize the right to use asset such that the asset is greater than the liability?

 

Sure. If you're paying below market rents and locked up for such a low rate for the future, then you should be able capitalize the between greater assets and liability. Whether asset will match with liability is a question for the accountants. It is better to reflect reality someway than leaving it out from the balance sheet and in the disclosure.

 

Back to the original question:Yes, operating leases should be capitalized as assets an liabilities on the balance sheet as finance leases. The only difference bw finance and operating leases is ownership, but both are contractually liable. Capitalizing operating leases will allow investors to have a better picture about the company;s  D/E ratio.Hiding operating leases in disclosures is definitely not the solution.

[txlaw]

Question: Will the right to use asset always match up one for one with the operating lease liability? 

 

Like, say, you have long term real estate leases where you are paying below market rent, and then you sublease the real estate, earning a spread.  Do you capitalize the right to use asset such that the asset is greater than the liability?

 

Sure. If you're paying below market rents and locked up for such a low rate for the future, then you should be able capitalize the between greater assets and liability. Whether asset will match with liability is a question for the accountants. It is better to reflect reality someway than leaving it out from the balance sheet and in the disclosure.

 

Interesting.  So it sounds like equity for companies with below market rents could go up as a result of putting below market operating leases on the balance sheet.

[SharperDingaan]

It would be better to keep them off BS & tighten the footnote disclose. Basel Risk Weighted Assets would rise & most banks would have to increase their capital by around 15% of the offsetting asset. For a bank lending at 20x capital (conservative), & a (conservative) 150bp spread (borrow EFSF, buy sovereign), this could be costly.

 

ie:  100M of operating lease x 15% x 20 = 300M lending reduction.  300M x 150bp = 4.5M/yr of less margin. This operating lease has to be making you AT LEAST 4.5%/yr - just to break even.