Hello! I’m a first year equity analyst. I would like your thoughts on the following adjustment to operating leases, which in my opinion reflect better the economic reality of leases.
First, I would argue that an operating lease is equivalent to buy an asset with debt (that is, equivalent to capex financed with debt). So, in the income statement, I would take the operating lease expense and separate it’s principal and interest component. The principal component should be treated as depreciation (of the ROU) and the interest component should be moved down to financing costs.
Then, in the cash flow statement, I would add back the depreciation of the ROU as a non cash adjustment to operating cash flows, and create and equivalent cash outflow in the cash flows from financing activities, named principal repayment of operating lease.
Then, I would consider the new ROU created in a given year as Capex in the cash from investing activities, and create an equivalent account in the cash from financing activities named proceeds new from operating leases.
That way, the final cash flows aren’t modified, but free cash flow is modified to better reflect the reality of operating leases; that is, new ROU is Capex, which is financed with new debt (operating lease debt). The expense is depreciation of the ROU and a principal repayment on debt.
Thoughts? Is this logic correct?