Accounting for Operating Leases  445
Exhibit 22.2 presents the financial statement accounts related to leases for 
FlightCo and shows how the accounts evolve over time. Although the evolu-
tion is neither required for valuation nor disclosed in practice, it will be help-
ful for explaining the accounting behind leases.
On the income statement, U.S. GAAP requires the total lease payments of 
$30 million to be spread evenly over the life of the contract, even though the 
cash payments change over time.3 The annual lease expense is recorded on 
the income statement at $10 million per year. The lease payment covers the 
depreciation of the asset, as well as financial compensation for the lessor.
On the balance sheet, the present value of lease payments is recorded as 
a “right-of-use” asset, and the corresponding liability is recorded as an “op-
erating lease.” Both accounts start at $27.1 million—the present value of the 
lease. While the two accounts will match when initially recorded, they will 
EXHIBIT 22.1  FlightCo: Valuation of Operating Lease
$ million
Lease payment
Discount factor
Discounted 
cash flow
Year 1
9.0
0.952
8.6
Year 2
9.0
0.907
8.2
Year 3
12.0
0.864
10.4
Present value of operating lease
27.1
EXHIBIT 22.2  FlightCo: Financial Statement Accounts Related to Leases
$ million
Year 1
Year 2
Year 3
Income statement
Lease expense
10.0
10.0
10.0
Assets: Right-of-use asset
Right-of-use asset, start
27.1
18.5
9.4
Lease expense
 (10.0)
(10.0)
(10.0)
Embedded interest1
1.4
1.0
0.6
Right-of-use asset, end
18.5
9.4
–
Liabilities: Operating lease
Lease principal, start
27.1
19.5
11.4
Interest at 5%
1.4
1.0
0.6
Lease payment
(9.0)
(9.0)
(12.0)
Lease principal, end
19.5
11.4
–
1 Under U.S. GAAP, the interest on the operating lease liability is netted against the lease expense to determine the annual reduction in the right-of-use asset.
3 Some might think the expense accounting for operating leases mirrors that of finance leases; it does 
not. In a finance lease, the present value is straight-line amortized over the life of the lease. If FlightCo’s 
lease were a finance lease, amortization expense would equal $9.03 million per year for three years. 
Lease amortization is included in the depreciation and amortization. Lease interest expense is calcu-
lated on the liability and included in interest expense.

446  Leases
not match over time if cash payments vary year to year. That is the case in our 
FlightCo example. The right-of-use asset will decline $8.6 million in the first 
year (from $27.1 to $18.5 million), equal to the lease expense of $10.0 million 
less interest of $1.4 million. (As if this were not confusing enough, interest is 
calculated on the operating lease liability, not the asset.) In the same year, the 
operating lease liability declines by $7.6 million (from $27.1 to $19.5 million), 
equal to the cash payment of $9.0 million less the interest of $1.4 million.
Because of the mismatch described in the previous paragraph, most 
­companies report operating lease liabilities that differ from their correspond-
ing right-of-use assets. Delta Airlines, for example, reported $6.0 billion in 
right-of-use assets in its 10-Q for the first quarter of 2019. In contrast, current 
maturities of operating leases equal $941 million, and noncurrent operating 
leases equal $5.8 billion, totaling $6.7 billion. In this reporting period, the cor-
responding values differ by more than 10 percent.
Valuing a Company with Operating Leases
Incorporating operating leases into an enterprise valuation follows the same 
process outlined in Part Two of this book. We use four steps to value FlightCo:
1. Reorganize the financial statements. During the reorganization, adjust 
earnings before interest, taxes, and amortization (EBITA) upward by re-
moving the implicit interest in operating lease expense. Adjust operat-
ing taxes to determine adjusted net operating profit after tax (NOPAT).
2. Estimate free cash flow (FCF), using adjusted NOPAT and changes in 
the right-of-use asset. Liabilities classified as operating leases should be 
treated as debt and incorporated into the reconciliation of free cash flow.
3. Estimate a weighted average cost of capital (WACC) that includes the 
value of the operating lease liability as debt.
4. Value the enterprise by discounting free cash flow (based on the ad-
justed NOPAT) at the WACC, including operating leases. Subtract tra-
ditional debt and the value of operating lease liability from enterprise 
value to determine equity value.
As long as you treat right-of-use assets as purchased equipment and 
treat the operating lease liability as a form of debt, your results will 
be theoretically consistent. Only operating profit requires an upward 
adjustment for implicit lease interest. Failing to adjust operating profit 
will undervalue equity, because implicit interest would be double-
counted: once as part of lease expense and again as part of lease value 
when subtracting the value of leases from enterprise value to get to 
equity value.