Operating Leases – Invested Capital Adjustment

This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.

Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide balance sheet issues and obscure the true amount of capital invested in a business.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

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Before 2019, operating leases, unlike capital leases or debt-financed purchases, were not recognized on the balance sheet. The only trace of operating leases on the financial statements was a rental expense, often bundled within other items on the income statement (part of this rental expense is an implied interest expense that we remove). Starting in calendar year 2019, the Financial Accounting Standards Board (FASB) implemented Accounting Standards Update 2016-02 (Topic 842), which requires companies to record operating lease assets and liabilities on the balance sheet. Prior to this requirement, we converted all operating leases to capital leases to ensure comparability despite different accounting. We made this adjustment by adding the discounted present value of all required operating lease payments to our calculation of invested capital.

For periods after 2019, we account for operating leases as explained below.

Since ASU 2016-02 went into effect, companies have found other ways to continue to hide lease debt from their balance sheets as detailed in Variable Leases Under ASC 842: First Evidence on Properties and Consequences. As a result, we’ve further updated our models to ensure they capture all liabilities related to operating leases, such as Variable and Not-Yet-Commenced leases. Details here.

Any lease not meeting all the specific criteria of a capital lease is classified as operating. With the implementation of ASU 2016-02, companies now must capitalize their operating leases, like capital leases, by reporting the assets and liabilities on the balance sheet.

To capitalize operating leases, companies will use an internally derived discount rate. Lessees are required to use the rate implicit in the lease (RIIL). Determining the RIIL, however, requires information from the lessor that is not often readily available. As a result, companies will often use their collateralized incremental borrowing rate (IBR) as an alternative. Most publicly traded companies issue uncollateralized debt, so determining a collateralized IBR can be challenging and complicated.

The capitalized operating lease liability, and corresponding assets, are then reported on the balance sheet. The assets are categorized as right-of-use (ROU) and can be found as individual line items on the balance sheet or bundled within property, plant, and equipment (PP&E) or other assets. The liabilities are categorized as operating lease liabilities and can be found as individual line items on the balance sheet or bundled with other current and long-term liabilities. Occasionally, companies will disclose a single lease liability comprised of both operating and capital leases, with a breakout in the notes separating the two.

While companies are restricted in how they determine their collateralized IBR, they have some control over the assumptions. To mitigate their ability to manipulate the collateralized IBR, we use a standardized operating lease discount rate for every company we cover. We then replace the company’s calculation of capitalized operating leases with our calculation. The total operating lease adjustment to invested capital is the difference between our capitalized operating leases and a companies reported value.

Figure 1 shows the 5 largest differences between our NPV of operating leases and the reported NPV of operating leases in 2022, where our calculation is higher than reported.

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