443 22 Leases Many companies, especially retailers and airlines, lease their assets from other companies rather than purchasing the assets outright. They do this for many reasons, including greater flexibility and to lower taxes. In the past, clever use of accounting rules allowed companies to keep as- sets and debts off balance sheets. These included leased assets and their cor- responding debts, securitized assets like receivables, and unfunded retirement obligations. In some cases, this helped companies manage cash flow or take advantage of alternative routes to raise funds. In other instances, off-balance- sheet items were used to artificially boost results such as earnings per share or return on assets. In response, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) made significant changes to their guidelines. As of 2019, companies are required to capitalize nearly all asset leases, including operating leases, on their balance sheet.1 This stands in stark contrast to past guidelines, where a company could rent an asset, even for long periods, and recognize only the periodic rental expense. The new accounting guidelines bring the treatment of operating leases closer to the underlying principles of this book. Implementation of the new guidelines, however, differs across accounting bodies, so incorporating oper- ating leases into your valuation still requires special care. This chapter begins with a review of the new accounting rules, how they differ across accounting bodies, and how they are presented on the financial statements. We then outline how to incorporate operating leases into an en- terprise valuation. Since operating leases affect each part of the valuation, this chapter provides a review of the valuation principles outlined in Part Two. As companies will not revise their historical financial statements, we discuss how 1 The International Accounting Standards Board (IASB) published IFRS 16, “Leases,” in January 2016, and the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, “Leases (Topic 842)” in February 2016. 444  Leases to adjust past financial statements to assure consistent benchmarking over time. The chapter concludes with a discussion of an alternative method for lease valuation, which can be helpful when benchmarking across companies. Accounting for Operating Leases Although both IASB and FASB now require capitalization of operating leases, there are differences in implementing the new standards. For companies that use International Financial Reporting Standards (IFRS), nearly all leases greater than one year are treated as “finance” leases, meaning that leased as- sets and their corresponding liabilities are capitalized on the balance sheet, and lease expense is appropriately split between depreciation and interest expense. The enterprise valuation methodology outlined in Part Two of this book will correctly incorporate leases under IFRS without further adjustment. Capitalizing leases under U.S. Generally Accepted Accounting Principles (GAAP) is more complicated. Companies classify asset leases into either “fi- nance” leases, similar to IFRS, or “operating” leases. A lease is classified as a finance lease if cumulative payments to the lessor exceed certain thresholds.2 Finance leases are not typically visible on the financial statements, as each element is embedded within another financial statement account. The leased asset is included with property, plant, and equipment. The leased liability is included with short-term and long-term debt. To better understand the impact of the new accounting guidelines, we ana- lyze and value FlightCo, a hypothetical airline that uses operating leases. To avoid the unnecessary complexities of continuing value, we assume the com- pany leases only one aircraft and plans to liquidate at the end of the third year. At that point, parts inventory is sold, general obligation debt is retired, and a liquidating dividend is paid. The lease is classified as an operating lease because the contract length is significantly shorter than the life of the underlying asset. Exhibit 22.1 presents the valuation of FlightCo’s operating lease using dis- counted cash flow. The lease has payments of $9 million, $9 million, and $12 million in years 1 through 3, respectively. Using discounted cash flow at a cost of debt of 5 percent, the lease has a present value of $27.1 million. Because the contract life is only three years, the present value of lease payments is sig- nificantly lower than the asset’s actual value. Later in this chapter, under “An Alternative Method for Valuing Operating Leases,” we present a valuation method for estimating the full value of leased assets using data in the annual report. This is helpful when benchmarking two companies that have different financing policies. 2 A lease is classified as a finance if the lease term is greater than 75 percent of the useful life, if the present value of lease payments is greater than 90 percent of the original cost, if the asset is specialized and has no value to the lessor once returned, or if ownership of the asset is transferred to the lessee at the end of the lease.