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To answer this question, let’s consider an example. Assume following is an annual statement of a public company. “At December 31, 2000, the Company was lessee at 7,000 restaurant locations through ground leases (the Company leases the land and the Company or franchisee owns the building) and at 6,000 restaurant locations through improved leases (the Company leases land and buildings). Lease terms for most restaurants are generally for 20 years and, in many cases, provide for rent escalations and renewal options, with certain leases providing purchase options. For most locations, the Company is obligated for the related occupancy costs including property taxes, insurance and maintenance. In addition, the Company is lessee under non-cancelable leases covering offices and vehicles. Future minimum payments required under existing operating leases with initial terms of one year or more are:

Rent expense was (in millions): 2000–$886.4; 1999–$796.3; 1998–$723.0. These amounts included percent rents in excess of minimum rents (in millions): 2000–$133.0; 1999–$117.1; 1998–$116.7. “ To capitalize these operating leases, we need to discount the future lease payments to arrive at the present value (PV). Here are the steps:

1. Cash flow for the FY2000 – 2005 are already given. So, we proceed to Step 2
2. Divide the “Thereafter” amount ($6,240M) by FY2005 amount ($640M) to determine the number of years remaining, at FY05 level, for the lease payments.

 6,240/640 = 10 years remaining

Put $624M (=$6,240M/10) for the additional 10 years after the lease amount of FY2005 for the PV calculation.

3. Consider its long-term borrowing rate (6%) to match the long-term assets.

4. Calculate the Present Value(PV) of this cash flow.

Now, let’s adjust the financial statements. Capitalizing operating leases does not affect net income; it just replaces the lease expense with interest expense and depreciation

5. $6.5B is added to the ‘Long-term Asset’ of the Balance Sheet as “Assets Under Capitalized Leases”. A similar amount is also added to the ‘Liabilities’ as “Capitalized Lease Obligations”. Now, this represents as if the company had purchased the assets with borrowed money as of 1/1/2000.
6. Reverse the existing entry ‘Lease Expense’ currently in the financials. The company paid $886.4M in FY2000.
7. Calculate the PV of FY2000 interest payment.

$6.5B x 6% = $390M

Since the company paid $886.4M in FY2000, the difference amount of $496M (=$886.4M – $390M) is added to the depreciation, resulting in no change in the net income value.

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