Question

Two types of lease accounting method:

Capital Lease

Operating lease

Leases that meet any of the following criteria is a capitallease:

1. Leases which transfers substantial ownership and risk to thelessee.

2. Leases with a bargain purchase options

3. Leases with tenure equal to 75% or more of the usefuleconomic life of the leased assets.

4. Leases in which the present value of minimum lease paymentsis equal to 90% or more of the fair market value at the inceptionof the lease.

Any other lease is operating lease.

Operating lease are treated as an expense and appears in theIncome Statement while Capital lease is treated as an Asset andLiability in the Balance Sheet

The effect on the financial statements of operating versuscapital lease treatment can be

significant. Consider the lease accounting impact on tworatios?debt-to-equity

(liabilities/equity) and asset turnover (sales/assets)?for thefollowing four companies in

2001, shown below:

Debt-to-Equity Asset

Reported Ratio With Reported Turnover with

Debt-to-Equity Operating Leases Asset

Operating

Leases

Ratio Capitalized Turnover Capitalized

Wal-Mart 1.38 1.50 2.63 2.51

McDonald's 1.38 1.96 0.66 0.53

Home

Depot 0.46 0.65 2.03 1.79

FedEx 1.26 2.57 1.47 0.93

The adjusted numbers were estimated using financial statementdisclosures discussed

later in this chapter. The debt-to-equity ratio is a measure of acompany?s leverage, and

the asset turnover ratio is a measure of a company?s efficiency inusing its assets to

generate sales. In each case, the operating lease treatment used bythe companies makes

them appear less leveraged and more efficient.

With the issuance of FASB Statement No. 13, it was thought thatfinancial statements would

reflect the economic reality of firms? lease agreements. However,the lease standard has been

relatively ineffective in meeting its objective. Instead ofcomplying with the spirit of the standard,

firms have gone to great lengths to structure leases that do notmeet the criteria for balance sheet

recognition. In an attempt to keep ahead of the clevermanipulations employed by firms to avoid

capital lease treatment, the FASB has had to amend and interpretthe lease standard more than a

dozen times. Scanning the list of FASB pronouncements following theissuance of Statement No.

13, it can be seen that portions of Statement No. 13 have beenamended or superseded by

Statements Nos. 17, 22, 23, 26, 27, 28, 29, 34, 71, 77, 91, 96, 98,109, and 125. In addition, the

FASB has released Interpretations 19, 21, 23, 24, 26, and 27 andissued 10 Technical Bulletins to

clarify certain aspects of the lease standard. In spite of allthis, firms still manage to treat the large

majority of their long-term, noncancelable leases asoff-balance-sheet operating leases.