Capital Leases

Capital Leases (also known as 'Finance Leases' under current accounting standards) are a type of long-term rental agreement that, for all intents and purposes, is a purchase in disguise. Think of it as a corporate “rent-to-own” deal. When a company enters a capital lease for a big-ticket item—like a factory, a fleet of trucks, or a specialized machine—it's committing to use that asset for most of its useful life and pay for nearly its entire value. From an accounting standpoint, the game is up: you can't just pretend you're renting. The company must record the leased item as an asset on its balance sheet, and the obligation to make lease payments as a form of debt. This provides investors with a much clearer view of the company's true financial commitments, preventing debt from hiding in the footnotes as it often did in the past.

In the old days, accountants played a fun game of “Is it a Capital Lease?” using a four-part test. If a lease met any of the following criteria, it had to be capitalized:

• Ownership Transfer: The lease transfers ownership of the asset to the company by the end of the lease term.
• Bargain Purchase: The company has an option to buy the asset at a price significantly below its expected fair market value at the end of the lease (a deal too good to refuse).
• Lease Term: The lease term is for the major part of the asset’s economic life (a common rule of thumb was 75% or more).
• Present Value: The present value of the lease payments is substantially all of the asset’s fair value (the rule of thumb was 90% or more).

Today, new accounting rules (IFRS 16 and ASC 842) have simplified things. The new guiding principle is that nearly all leases longer than 12 months must be put on the balance sheet. This has largely eliminated the old distinction between capital leases and operating leases for balance sheet purposes, a huge win for investors seeking transparency. However, understanding the old criteria still helps you grasp the economic reality of the commitment a company is making.

For a value investor, digging into the details of debt and assets is non-negotiable. Understanding how leases are treated is crucial to assessing a company's true financial health.

The most important takeaway is that a capital/finance lease is debt. Before the new accounting rules, some companies skillfully used operating leases to make their balance sheets look stronger and less leveraged than they really were—a practice known as off-balance sheet financing. By forcing these obligations onto the balance sheet, investors can now more accurately calculate key leverage ratios like the Debt-to-Equity Ratio and the Debt-to-Asset Ratio. It pulls back the curtain, ensuring the amount of debt you see is closer to the amount of debt that actually exists.

Capitalizing a lease changes how it flows through all three financial statements, and the differences are important.

When a lease is capitalized, two things are added to the balance sheet:

• An Asset: A 'Right-of-Use Asset' is created, typically under Property, Plant, and Equipment (PP&E), representing the company’s right to use the leased item.
• A Liability: A 'Lease Liability' is recorded, representing the company's obligation to make future payments.

This increases both the asset and liability sides of the balance sheet, giving a more complete picture of what the company owns and owes.

Instead of a single, straight-line 'rent expense' you'd see with an old operating lease, a capital lease creates two distinct expenses:

• Depreciation Expense: The 'Right-of-Use Asset' is depreciated over the lease term.
• Interest Expense: The 'Lease Liability' is treated like a loan, so a portion of each lease payment is recorded as interest expense.

This structure front-loads the total expense. Because interest is highest when the liability balance is largest, the combined depreciation and interest expense is higher in the early years of the lease and lower in the later years. This can make a company’s profits appear to grow faster than they really are, a nuance an astute investor must watch for.

The cash payments are split up, which can flatter a company's operating performance:

• The interest portion of the payment is a cash outflow from operations (Cash Flow from Operations or CFO).
• The principal portion (the part that reduces the lease liability) is a cash outflow from financing (Cash Flow from Financing or CFF).

This is a critical difference. Under the old operating lease rules, the entire rent payment was an operating outflow. By shifting the principal portion to the financing section, a company's CFO can look stronger than it would otherwise.

A capital lease (or finance lease) is a purchase financed by debt, no matter what it's called. While modern accounting standards have forced most leases onto the balance sheet, it's still an investor's job to understand the nature of these obligations. Always check the financial statement footnotes for details on the terms and amounts of lease liabilities. Understanding lease accounting allows you to look beyond reported earnings and cash flow figures to see the true economic reality of a business—the bedrock of sound value investing.