Operating Leases: Impact of Constructive Capitalization

A method was developed for constructively capitalizing material long-term, noncancelable operating lease commitments. This method allows key financial statement ratios to be calculated as if the operating leases had been capitalized at their inception. Although the concern over off-balance sheet financing via operating leases is recognized by financial analysts, widely utilized databases of financial information and ratios do not routinely adjust for its effects. The impact of constructive capitalization on the return on assets and the debt-to-equity ratios is illustrated for a sample of firms. Evidence suggests that operating leases have a significant effect on these risk and return measures and indicates that the magnitude of the effect varies within and across industries in which operating leases are an important form of off-balance sheet investing and financial activity. Thus, constructive capitalization of long-term operating lease commitments is seen as an enhancement to the relevance and comparability of firm-specific measures of risk and performance.