Off-balance-sheet financing & operating leases: impact on lessee financial ratios

RMA Journal, The, Dec, 2006 by Bob G. Kilpatrick, Nancy L. Wilburn

A seemingly tiny change in lease terms can have a dramatic effect on a lease's classification and its resulting financial ratios. This article follows up on a 1991 study and shows the effects of "constructive capitalization" of operating leases. Firms have increasingly used operating leases as a source of off-balance-sheet financing, and a 2007 joint FASB/IASB project will comprehensively reconsider the existing accounting rules for leases.

This article represents one point of view on a controversial subject. For a completely different perspective on the topic of lease capitalization, visit www.elaonline.com/accounting to view the white paper "Lease Accounting: Separating Myth from Reality."

The RMA Journal invites letters and articles presenting additional perspectives.

Pursuant to the Sarbanes-Oxley Act, Securities and Exchange Commission (SEC) staff produced a report in June 2005 concerning arrangements with "off-balance-sheet implications," special-purpose entities, and transparency of filings by issuers. Most notable among the areas of off-balance-sheet arrangements is accounting for operating leases. Indeed, the SEC study estimates the total undiscounted future cash flows associated with off-balance-sheet operating leases for all U.S. financial statement issuers at over $1.25 trillion. Moreover, the SEC estimates that 63% of these companies report employing operating leases, and that the ratio of total cash flows related to non-cancelable operating leases to those of capital leases (which are reported on the balance sheet) could be as high as 25:1. Due to the significance of this off-balance-sheet liability, the SEC recommended that the Financial Accounting Standards Board (FASB) reconsider the current lease accounting standards and guidance. Around the same time, the Financial Accounting Standards Advisory Council's Results of the 2005 Annual FASAC Survey ranked lease accounting as one of the top five financial reporting areas on which the FASB should focus. In response to the recommendations of the SEC and FASAC, the FASB has undertaken a joint project with the International Accounting Standards Board (IASB) to comprehensively reconsider the existing accounting rules for leases, with formal deliberations to begin in 2007 (FASB 2006).

Lease structuring to meet various accounting goals has developed into an industry since the passage of Statement of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases (FASB, 1976). Web sites promote such lease designs, one of which is described under the title "Tailoring an Operating Lease to Fit Your Company," in which common tactics are described to help companies avoid capitalization of leases. While the SEC report indicates that the use of operating leases as a source of off-balance-sheet financing is widespread, the report does not provide evidence that companies employ them to a larger extent than in past years.

Accounting for Leases

SFAS No. 13 provides the current rules for leases. In general terms, the lessee classifies leasing transactions under one of two categories. If sufficient risks and rewards of ownership are transferred to the lessee, the lessee records the transaction as a purchase (i.e., a capital lease); absent the transfer of sufficient risks and rewards of ownership, the lessee records the transaction as a rental (i.e., an operating lease).

SFAS No. 13 specifies four main criteria for treating a lease as a capital lease by the lessee:

1. The lease transfers ownership to the lessee at the end of the lease term.

2. The lease contains a bargain purchase option, under which the lessee can purchase the leased property at a price significantly below the expected fair value of the leased property at the end of the lease term.

3. The term of the lease (plus any bargain renewal option) is equal to or greater than 75% of the estimated economic life of the leased property.

4. The present value of the minimum lease payments to be made by the lessee (excluding executory costs such as insurance, maintenance, and taxes) is equal to or greater than 90% of the fair value of the leased property.

Thus, SFAS No. 13 creates an all-or-nothing, or "bright-line," approach for lessees. If any of the above criteria are met, the lessee records an asset and a related liability for the present value of the required minimum lease payments on its balance sheet. Annual expenses include imputed interest charges on the lease obligation and depreciation on the capitalized lease asset. If none of the above criteria are met, the lessee treats the lease arrangement as an operating lease. Since this treatment is essentially that of a rental contract, the lessee does not record an asset or a related liability for the future required lease payments on its balance sheet. Instead, the lessee records an annual rental expense on its income statement. These financial statement differences between a capital lease and an operating lease are summarized in Table 1.

SFAS No. 13 requires the lessee to disclose the future minimum lease payments (capital leases) or future minimum rental payments (operating leases) as of the balance sheet date, in the aggregate and for each of the five succeeding fiscal years. Additionally for capital leases, the lessee must disclose separate deductions for the amount of imputed interest necessary to reduce net minimum lease payments to present value. (1)