Operating leases adjustments
Hello! I’m a first year investment banking analyst. I would like your thoughts on the following adjustment to operating leases, which in my opinion reflect better the economic reality of leases.
First, I would argue that an operating lease is equivalent to buy an asset with debt (that is, equivalent to capex financed with debt). So, in the income statement, I would take the operating lease expense and separate it’s principal and interest component. The principal component should be treated as depreciation (on the ROU) and the interest component should be moved down to financing costs.
Then, in the cash flow statement, I would add back the depreciation of the ROU as a non cash adjustment to operating cash flows, and create and equivalent cash outflow in the cash flows from financing activities, named principal repayment of operating lease.
Then, I would consider the new ROU acquired in a given year as Capex in the cash from investing activities, and create an equivalent account in the cash from financing activities named "proceeds from new from operating leases".
That way, the final cash flows aren’t modified, but free cash flow to the firm is modified to better reflect the reality of operating leases; that is, new ROU is Capex, which is financed with new debt (operating lease debt). The expense is depreciation of the ROU and an equivalent amount is considered principal repayment on debt.
Thoughts?
Ah, swinging from the trees of financial adjustments, I see! Your approach to adjusting for operating leases is quite thoughtful and aims to reflect the economic substance over the legal form of the leases. Let's peel this banana layer by layer:
Operating Lease as Debt: You're correct in treating an operating lease as a form of debt. This aligns with the new accounting standards, specifically ASC 842, which requires companies to recognize operating leases on the balance sheet, thereby increasing transparency about the company's leverage and commitments.
Income Statement Adjustment: Separating the operating lease expense into principal and interest components is a method that mirrors the treatment of a finance lease. This would indeed provide a clearer picture of the company's operating expenses and financing costs.
Cash Flow Statement Adjustment: Adding back the depreciation of the Right-of-Use (ROU) asset as a non-cash adjustment to operating cash flows is consistent with the treatment of depreciation for other capital assets. Reflecting the principal portion of the lease payment as a financing outflow is also a logical step to show the repayment of the "debt" portion of the lease.
Capex and Financing Activities: Treating the acquisition of new ROU assets as Capex makes sense since it's an investment in a long-term asset. The offsetting "proceeds from new operating leases" would then represent the financing side of the transaction.
Your method essentially reclassifies operating leases to align with the economic reality of financing an asset purchase, which can be quite insightful for financial analysis. It provides a clearer picture of a company's investment activities and the true cost of financing its operations.
However, it's important to note that while this approach can be useful for internal analysis or sophisticated investors, it may not be in compliance with generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS). Therefore, while it's a valuable analytical tool, one must be cautious when applying it to official financial statements or communications to ensure compliance with the relevant accounting standards.
Based on the most helpful WSO content, it's clear that the finance community is still grappling with the best way to handle these adjustments post-ASC 842. It's a topic ripe for discussion, and your approach adds a valuable perspective to the conversation. Keep swinging through those financial statements, and don't hesitate to reach out if you need more insights!
Sources: Adjusting EV for Operating Lease Liabilities?, Beyond the guide: a list of real interview technical questions, Your Thoughts on An Office Acquisition Deal
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