Leases

Why this matters

Retailers rent stores, airlines rent aircraft, and many companies rent offices, warehouses, and vehicles. A ten-year lease is a ten-year promise to pay. If the company had borrowed to buy the same building, the loan would be plainly visible as debt. Leases have to be understood the same way, or a company that rents everything will look far less indebted than one that owns.

On the balance sheet

For a long time most leases weren't on the balance sheet at all. The earlier rules didn't require lease assets and liabilities to be recorded for most leases, and the commitments appeared only in the notes. The current US standard is built on a single principle: a company that leases should record the assets and liabilities that arise from its leases.¹

At the start of a lease the company records two things, both measured at the present value of the payments it has committed to:¹

• A lease liability: what it owes.
• A right-of-use asset: its right to use the item for the term of the lease.

Present value means the future payments are discounted back to today, as Time Value of Money and Discount Rates explained.

STU Corp leases a warehouse	Amount
Rent, paid at the end of each year	$2.0 million
Term	5 years
Total payments	$10.0 million
Discount rate	6%
Present value of the payments	$8.4 million

On day one STU Corp records a right-of-use asset of $8.4 million and a lease liability of $8.4 million. Its total assets and total liabilities both rise by that amount. Nothing has been paid yet.

Two kinds of lease, two patterns of expense

The balance sheet treats all leases alike. The income statement doesn't. US rules keep two categories:¹

• An operating lease is closest to renting. The company records a single lease cost, spread evenly over the term. All of the cash paid counts as an operating cash flow.
• A finance lease is closest to buying with a loan, for example when the lease covers most of the asset's life or ownership passes at the end. The company records amortization of the asset and, separately, interest on the liability. The principal part of each payment counts as a financing cash flow, and the interest as an operating one.

Year	Operating lease: lease cost	Finance lease: interest	Finance lease: amortization	Finance lease: total
1	2.0	0.5	1.7	2.2
2	2.0	0.4	1.7	2.1
3	2.0	0.3	1.7	2.0
4	2.0	0.2	1.7	1.9
5	2.0	0.1	1.7	1.8
Total	10.0	1.5	8.5	10.0

Both add up to the $10 million actually paid. The finance lease costs more in the early years, because interest is charged on a larger balance at the start, and less later. Amounts are rounded, so the amortization column shows 8.5 where the precise total is 8.4.

The larger effect is on where the cost appears:

With a finance lease, the cost sits in amortization and interest, both of which EBITDA leaves out. So the same warehouse, on the same terms, makes EBITDA $2 million higher if it's a finance lease, and operating cash flow $1.5 million higher. The company is no better off.

The rest of this lesson is for members

Still to come in this lesson: Comparing companies, What stays off the balance sheet, Where to look, the key takeaways, and 2 quiz questions with explanations.

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