Food. Water. Shelter. The trifecta of essentials that has been grilled into anyone who has ever participated in Boy Scouts, Girl Scouts, Rangers, or any other activity involving wilderness survival training.

Companies must survive too and have these needs as well. Almost all businesses need a shelter or a space from which to perform operations, whether that is a retail store, a manufacturing plant, or an office filled with computers and Ping-Pong tables.

Due to the high costs of purchasing equipment and property, many businesses enter lease contracts to rent these items and use them in daily operations.

investing 101:  What are operating leases?

An operating lease is the contract requiring a company to make regular payments in exchange for renting property or equipment.

Why are they important?

Operating leases are the largest and most widespread example of off-balance sheet debt. Current accounting standards only require companies to report their future lease obligations in the notes to the financial statements. Companies are not required to include this item in liabilities on the balance sheet. By not accounting for leases, one incorrectly assumes a company to be more liquid than it is.

How should they be treated?

Operating leases represent a liability to the company as a future cash obligation it is contractually bound to pay. The present value of future lease payments should be added to the company's debt in order to accurately account for the amount of leverage a company uses to afford its capital expenditures.

How do operating leases affect earnings?

Operating leases generally have contracts that last over a period of years, which creates a problem for accountants.  Due to the matching principle, in which expenses are only recognized in the period in which they help to create revenue, operating lease expenses will only be expensed for that period.  A five-year contract's cost will be spread out over those five years and deducted from revenue incrementally.