Two types of lease accounting method:
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:
Reported Ratio With Reported Turnover with
Debt-to-Equity Operating Leases Asset
Ratio Capitalized Turnover Capitalized
Wal-Mart 1.38 1.50 2.63 2.51
McDonald's 1.38 1.96 0.66 0.53
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13, it can be seen that portions of Statement No. 13 have beenamended or superseded by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.