Academic journal article Journal of Case Studies

Accounting for Leases: Operating or Capital-Does It Really Matter?

Academic journal article Journal of Case Studies

Accounting for Leases: Operating or Capital-Does It Really Matter?

Article excerpt

Rachel Spiro was puzzled. Her intermediate accounting professor began a series of lectures on accounting for leases, however, Rachel left the classroom after the first lecture with more questions than when she entered. The most pressing in her mind was how could the Financial Accounting Standards Board (FASB) let companies get away with not reporting multiple-year, noncancellable contracts which grant them the extended right of use of a valuable asset? The professor had stated that the total expense for an operating lease would equal the total expense for a capital lease over the life of the contract, so Rachel thought, "Does it truly matter how an entity classifies a lease: operating vs. capital?"

The professor had introduced the topic by first explaining that accounting for leases was not a "one size fits all" exercise: the FASB classifications varied such that under one scenario the standards required companies to add certain leased items to the balance sheet as assets with a corresponding liability (capital lease), yet in another, the payments for use of the item were considered operating expenses with no asset or liability recorded (operating lease). "Wouldn't these different classifications open the door for earnings management?" Rachel thought. "Surely, if given a choice, wouldn't companies always choose to report more assets and fewer expenses in any given reporting period? Besides, by classifying these contracts as operating leases and recording related expense in the period, wouldn't that result in better adherence to the Matching Principle we learned so much about in the Conceptual Framework?" Unfortunately, Rachel's professor had an administrative meeting immediately after class and was not available to address the many questions she raised. Rachel kept replaying in her mind one statement that the professor made: the standard was meant to prevent companies from engaging in off-balance-sheet financing. What exactly did that mean?

Rachel wasn't willing to wait until the next class to have these questions answered and was determined to seek out the information on her own. Her first step was to gain a better understanding of the term "off-balance-sheet financing". She referred to her Spiceland's Intermediate Accounting textbook where she learned it was the practice of structuring long-term contracts such that no liability is recorded on the balance sheet. The textbook went on to say, "some firms try to obscure the realities of their financial position through off-balance-sheet financing [thereby] avoiding violating terms of contracts that limit the amount of debt a company can have.... [Operating leases are] sometimes used as a means of off-balance-sheet financing."

Armed with that information, Rachel needed to see if or how these different classifications of leases manifested themselves within the story of a real company. She remembered that her accounting professor had mentioned the airline industry as one that relied heavily on leases for its flight equipment. She turned on her laptop, Googled "Delta Airlines" and accessed the company's latest financial statements at http://ir.delta.com/stock-and-financial/secfilings/default.aspx. The consolidated balance sheets, statements of operations and cash flows and relevant financial statement footnote disclosures that Rachel reviewed appear in Tables 1-5.

Rachel combed over Delta's financial statements and footnotes noting the company had leases of both types: capital and operating. Of particular interest was the Lease Obligations Footnote which detailed the total amount owed under both categories of leases. She noted as of December 31, 2013, the present value of future minimum capital lease payments was $497 million, far less than the $9.87 billion owed in operating lease payments (almost twenty times less).

Rachel knew that the only way to truly understand the financial statement impact of the different lease classifications would be to convert the operating leases to capital leases. …

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