Academic journal article Academy of Accounting and Financial Studies Journal

Analyzing Creditworhtiness from Financial Statements in the Presence of Operating Leases

Academic journal article Academy of Accounting and Financial Studies Journal

Analyzing Creditworhtiness from Financial Statements in the Presence of Operating Leases

Article excerpt


The leasing market in the U.S. is very large. Some estimates show that more than half of all public and private investment in equipment and software in the U.S. is currently being acquired under leases (Equipment Finance and Leasing Foundation, 2007) with comparable results found in the acquisition and use of real estate assets, automobiles and airplanes, and many other tangible assets.

Leases are contractual obligations that allow assets owned by one party to be used by another party, for specified periods of time, in return for a payment or series of payments. Companies choose to lease assets for a variety of reasons, including economies of scale or scope, increased flexibility, tax advantages, improved access to capital, reduced costs of upgrading equipment, and improved risk sharing (SEC, 2005).

The accounting guidelines that pertain to leases are primarily dictated by Statement of Financial Accounting Standard 13 (SFAS 13) Accounting for Leases, which was issued in 1976. This statement provided a two-pronged approach to accounting for leases. Leases that transferred most of the benefits and responsibilities of ownership to the party using the asset would be treated as economically similar to sales with attached financing agreements, and generally referred to as "capital" leases. The user of the asset (the lessee) would record the asset and a related liability on its balance sheet in an amount estimated as the present value of the required lease payments with periodic write-offs incorporating the depreciation (amortization) of the asset, associated operating expenses such as property taxes, and the implicit financing charges.

Leases not considered capital leases were labeled "operating" leases and accounted for as rental contracts. The company using the asset would not record the asset or the related liability for future contractual rental payments on its balance sheet, but would instead record a periodic rental expense. SFAS 13 specified that a lease would be deemed a capital lease if 1) the lease transferred ownership to the lessee using the asset by the end of the lease term or through a bargain purchase option; 2) the term of the lease was at least 75 percent of the estimated economic life of the leased property; or 3) the present value of the minimum lease payments to be made by the lessee was at least 90 percent of the fair value of the leased asset. Leasing agreements that did not involve any of these requirements could be accounted for as operating leases.

Although the distinction made between capital leases and operating leases is usually straightforward, there are many issues such as contingent and variable payment requirements, optional term extensions, and other clauses that complicate the analysis. Nonetheless, such a distinction must be made to properly account for the transactions. Whether considered capital or operating leases, each still has extensive disclosure requirements. For example, companies must provide the following information: a description of the nature of leasing arrangements; the nature, timing and amount of cash flows associated with the leases; the amount of lease revenues and expenses reported in the income statement each period; and any additional information pertinent to the balance sheet classification of the various components of the leasing arrangements.

Unfortunately, the accounting guidance for leases has produced a situation in which similar transactions can receive different accounting treatment depending on very artificial distinctions. For example, a lease requiring payments equaling 89 percent of an asset's fair value would be treated as an operating lease while one with payments equaling 90 percent would be a capital lease, despite the two arrangements being very similar from an economic perspective. Likewise, there are significant economic differences between a one-month lease and a 10-year lease for the use of a building, yet they would likely each have similar accounting requirements as both would likely qualify as operating leases. …

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