Tuesday, December 22, 2009

Capital and Operating Leases from an Investment Perspective

I received a very insightful (and lengthy, WHEW!) email from Josh in Louisville about the distinction between capital and operating leases and how investors should distinguish between the two.

Josh, as promised, here is your answer.

Accountants draw distinctions between capital and operating leases because of FASB rules, especially SFAS No. 13 (1976). To oversimplify the analysis it all comes down to whether an asset is "leased" or really is actually "sold" in some sort of delayed way, such as an installment sale or through a very cheap option price at the end of the lease term.

CEOs and CFOs of large companies also split hairs about the differences between the two types of leases, mostly because assets controlled under operating leases are not featured on the balance sheet and there is no corresponding liability attached. This allows for lots of accounting games, in other words, you can actually buy assets but not show any corresponding liabilities for the purchase on the balance sheet. These so-called "off-balance sheet liabilities" can often mean the difference between a positive or negative earnings per share number.

Many investors (like me) don't really care too much about the difference between capital and operating leases. Yes, there are certainly times when you need to capitalize the operating leases to get a better notion of how much a company really is earning and how much it is worth. After all, liabilities off the balance sheet do distort the genuine value of a company. A good example of this would be a company that leases many retail store locations for a very short period of time, such as only during the Christmas season.

But for me, in most circumstances, I really don't care.

The analysis here is easy.

Take, for example, a company that needs a machine or some property and is paying $5,000 a month to use it. Does it really matter that this $5,000 is an operating lease payment or essentially a disguised capital obligation? It is still the same $5,000 each month being deducted from earnings and cash flow. If you are measuring EPS or FCF per share does it really matter how the company spent this $5,000? It is still a cost of doing business no matter how you slice (or characterize) it.

For me, the distinction between operating and capital leases really becomes more of a credibility issue than an accounting one. When companies play lots of off-balance sheet liability games, such as through immediate sale/leasebacks of key assets, I get nervous. Why is it so important to keep all these liabilities off the balance sheet? What's really going on here? I like to see strong and clean balance sheets, not weak ones that just look strong and pretty.

This entire area of accounting involves lots of math, lots of rules, and lots of billable hours for accountants and lawyers. It is far more complex than it really needs to be and quite frankly, amounts to a hill of beans in most cases.

Fundamentally, I believe that all owners, CEOs, and CFOs should present the clearest and simplest picture of their company possible and generally this means if you lease an asset, you also have bought yourself a liability that should be disclosed on the balance sheet and not just as a footnote to the financial statements as is currently done with operating leases.

Robert J. Abalos, Esq.