Lease Accounting

Lease Accounting is the set of rules that dictates how a company must record its leasing activities. A lease is simply a contract where one party (the lessor) gives another party (the lessee) the right to use an asset—like a building, a fleet of trucks, or a photocopier—for a specific period in exchange for payments. For decades, many leases were kept “off the books,” making companies appear less indebted than they truly were. However, recent major changes, namely ASC 842 under U.S. GAAP and IFRS 16 internationally, have revolutionized this practice. The new standards force companies to recognize most leases on their balance sheet. This shift provides investors with a much clearer and more honest picture of a company's financial obligations, fundamentally changing how we analyze businesses that rely heavily on renting their core assets.

Imagine you want to assess a friend's financial health. You know they pay $500/month for a car. But is it a casual month-to-month rental they can cancel anytime, or are they locked into a five-year financing plan? The answer dramatically changes how you view their financial stability. For a long time, corporate accounting made this same distinction.

• The Old Way: Companies classified leases into two buckets. A finance lease (historically called a capital lease) was treated like a loan to buy an asset; both the asset and the debt appeared on the balance sheet. But an operating lease was treated like a simple rental. The payments were just an expense on the income statement, and the massive long-term obligation to pay rent was hidden away in the footnotes of the financial statements. For companies like airlines or retailers that lease nearly all their planes and stores, this meant billions of dollars in effective debt were invisible on their balance sheets.
• The New Way: Regulators decided this “hidden debt” was misleading. The new standards, ASC 842 and IFRS 16, largely eliminated the off-balance-sheet treatment for operating leases. Now, with few exceptions (like very short-term leases), all leases must be brought onto the balance sheet.

The core of the new rules is the creation of two new items on a company's balance sheet the moment it signs a lease.

When a company (the lessee) leases an asset, it must now record:

• A Right-of-Use (ROU) Asset: This represents the company's right to use the leased asset for the contract's term. It's listed on the asset side of the balance sheet.
• A Lease Liability: This represents the company's obligation to make all future lease payments. It's a debt and is listed on the liability side of the balance sheet.

The result? The company's balance sheet suddenly looks much larger. Total assets are higher, but so are total liabilities. This makes the company appear more capital-intensive and more leveraged than it did under the old rules.

For the company owning and leasing out the asset (the lessor), the accounting changes were far less dramatic. Their accounting continues to follow a model similar to the old rules, distinguishing between different types of leases based on the transfer of risks and rewards. For investors analyzing a company, the most significant changes to understand are on the lessee's side.

This isn't just an accounting exercise; it's a fundamental change in transparency that empowers investors. Warren Buffett famously complained for years about operating leases, calling them a “ruse” that understated a company's true liabilities. The new rules fix this.

As a value investor, you want the most accurate picture of a company's financial health. Lease accounting now puts a huge chunk of previously hidden debt right in front of you. This allows for a more meaningful calculation of key leverage ratios like the Debt-to-Equity Ratio and a more accurate calculation of Enterprise Value, which includes all debt. You are no longer flying blind or forced to dig through footnotes to estimate a company's real obligations.

This is a critical trap for the unwary. Under the old rules, rent was an operating expense, which reduced EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Under the new rules, that rent payment is split into two parts:

• An interest expense on the lease liability.
• A depreciation expense (or amortization) on the ROU asset.

Both interest and depreciation are added back to net income to calculate EBITDA. The result? A company's EBITDA automatically increases after adopting the new rules, even if its cash flow and business operations haven't changed at all! A company can suddenly look much more profitable on this one metric, but it's just an accounting illusion.

When analyzing a company, especially in lease-heavy sectors like retail, restaurants, and airlines, keep these points in mind:

• Compare Apples to Apples: When comparing a company's performance over time, be aware of when it adopted the new lease standards. Its EBITDA and debt levels will look very different before and after the change.
• Analyze the Cash Flow Statement: The new rules reclassify cash flows. The principal portion of a lease payment is now often a financing outflow, not an operating outflow. This can artificially inflate Cash Flow from Operations, a key metric for measuring a company's health. Always check the details.
• Read the Footnotes: The financial statement footnotes still contain gold. They provide details on the length of leases and the discount rates used to calculate the lease liability, which can tell you a lot about management's assumptions.