Leasing

Leasing is a financial arrangement where a company or individual can use an asset without owning it. Think of it as a long-term rental. The contract involves two main parties: the owner of the asset, known as the lessor, and the user of the asset, the lessee. The lessee makes regular payments to the lessor for an agreed-upon period. This is incredibly common in business for big-ticket items that companies need but might not want to buy outright, such as airplanes, corporate headquarters, fleets of trucks, or heavy machinery. For an investor, understanding how a company uses leasing is critical because it directly impacts its financial structure and reported profitability. It can be a smart, flexible financial tool or a way to hide obligations, so knowing the difference is key.

At first glance, you might wonder why a successful company wouldn't just buy the assets it needs. Leasing offers several compelling advantages that can be very attractive from a business strategy perspective.

• Preservation of Cash: The most significant benefit is that leasing avoids a massive upfront cash payment. Instead of spending millions on a new factory, a company can lease it and pay in smaller, predictable installments, freeing up its cash for other critical activities like research, marketing, or acquisitions.
• Flexibility: Business needs change. Leasing provides flexibility. If a company needs a specific type of equipment for only a three-year project, it can lease it for three years instead of buying an asset that might become useless afterward.
• Avoiding Obsolescence: In fast-moving industries like technology, equipment can become outdated quickly. Leasing transfers this risk of obsolescence to the lessor. The lessee can simply upgrade to the latest model when the lease term ends.
• Tax Advantages: Depending on the jurisdiction and the lease structure, lease payments can often be deducted as an operating expense, which can lower a company's taxable income.

Historically, leases were categorized into two main types, and the accounting treatment for them was worlds apart. While new accounting rules have bridged this gap, understanding the classic distinction is vital for analyzing older financial data and grasping the underlying economics of the transaction.

This is the “rent-to-own” version of leasing. A finance lease is economically similar to buying an asset with a loan. It's a long-term, non-cancellable agreement where the lessee essentially enjoys all the risks and rewards of ownership. A lease is typically classified as a finance lease if it meets certain criteria, such as:

• The lease term covers the vast majority of the asset's useful life.
• Ownership of the asset transfers to the lessee at the end of the lease.
• The present value of the lease payments is close to the asset's fair market value.

From an accounting perspective, a finance lease has always been recognized on the balance sheet. The company records the leased item as an asset and creates a corresponding lease liability, which is essentially a form of debt.

This is the “simple rental” version. An operating lease is typically for a shorter period, and the lessor retains the risks of ownership. Think of a company renting a photocopier for a year. Historically, the magic of the operating lease was that it was off-balance-sheet. The company didn't have to report the asset or any long-term liability. The lease payments were simply recorded as an operating expense on the income statement as they were paid. This made companies appear to have fewer assets and, more importantly, less debt than they actually did.

For a value investor, the goal is to understand the true economic reality of a business. For decades, operating leases were a major loophole that made this job harder.

Regulators eventually caught on to the fact that massive, long-term lease commitments were a form of debt in disguise. An airline with billions in future payments for its leased fleet was, for all practical purposes, just as indebted as an airline that borrowed billions to buy its fleet. To fix this, new accounting standards were introduced: IFRS 16 for international companies and ASC 842 in the United States. These rules, implemented around 2019, were a game-changer. They effectively eliminated the concept of the off-balance-sheet operating lease for most public companies. Now, nearly all leases longer than 12 months must be put on the balance sheet. This is done by recording:

• A right-of-use asset (representing the lessee's right to use the leased item).
• A lease liability (representing the obligation to make future payments).

This change was a massive win for investors, providing a much clearer and more honest picture of a company's total financial obligations.

Even with the new rules, a sharp investor should still pay close attention to a company's leasing activities.

1. Read the Footnotes: The notes to the financial statements are your best friend. Companies must disclose the details of their lease arrangements here, including a schedule of future payments. This schedule is a goldmine, telling you exactly how much cash the company is committed to paying out over the next one, five, or ten years.
2. Understand the “Why”: Ask yourself why the company is leasing. Is it for core, mission-critical assets (like a retailer leasing all its store locations)? This could be a risk if leases come up for renewal in a tough market and the lessor demands much higher rent. Or is the leasing for peripheral assets, offering genuine flexibility?
3. Historical Comparisons: When analyzing a company's performance from before 2019, you must mentally adjust for the old operating leases. A company's leverage ratios might look artificially low in 2017 compared to 2020, not because the business changed, but because the accounting rules did. Understanding this history is crucial for identifying long-term trends and assessing a company's true intrinsic value.