Most firm valuation models start with the after-tax operating income as a measure of the operating income on a firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume that the operating expenses do not include any financing expenses (such as interest expense on debt). While this assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease expenses are treated as part of the operating expenses, but we will argue that they really represent financing expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely used in valuation.
The operating income is a key input into every firm valuation model, and it is often obtained from an accounting income statement. In using this measure of earnings, we implicitly assume that operating expenses include only those expenses designed to create revenue in the current period, and that they do not include any financing expenses. For the most part, accounting statements separate out financing expenses such as interest expense and show them after operating income. There is one significant exception to this rule, and that is created by the accounting treatment of operating lease expenses, which are categorized as operating expenses to arrive at operating income. We will make the argument in this paper that these expenses are really financing expenses, and that ignoring this misclassification can create significant problems in measuring and comparing profitability. We also suggest two ways in which we can recategorize operating lease expenses as financing expenses. The Accounting Treatment of Leases Firms often have a choice between buying assets and leasing them. When, in fact, assets are leased, the treatment of the lease expenses can vary depending upon how leases are categorized and this can have a significant effect on measures of operating income and book value of capital. In this part of the paper, we will begin by looking at the accounting treatment of leases and how it affects operating earnings, capital and profitability. Operating versus Financial Leases: Basis for Categorization An operating or service lease is usually signed for a period much shorter than the actual life of the asset, and the present value of lease payments are generally much lower than the actual price of the asset. At the end of the life of the lease, the equipment reverts
back to the lessor, who will either offer to sell it to the lessee or lease it to somebody else. The lessee usually has the option to cancel the lease and return equipment to the lessor. Thus, the ownership of the asset in an operating lease clearly resides with the lessor, with the lessee bearing little or no risk if the asset becomes obsolete. An example of operating leases would be the store spaces that are leased out by specialty retailing firms like the Gap. A financial or capital lease generally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. A financial lease generally cannot be canceled, and the lease can be renewed at the end of its life at a reduced rate or the asset acquired at a favorable price. In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee consequently reduces the lease payments, leading to what are...