Hidden Risk Behind The Lease Accounting

Lease accounting has been a disaster for a very long time. Many Corporate managers can deceive investors and creditors by reporting leases as operating leases and pretend that they do not have any lease obligations. How does it work? This post investigates lease accounting and describes how corporate managers try to argue that their leases are operating leases for the purpose of hiding lease liabilities from investors and creditors.

Leases, of course, involve a lessor who legally owns some property and a lessee who would like to utilize that property. The lessor agrees to lend the property to the lessee, while the lessee agrees to make certain payments.

Suffice it to say that the Financial Accounting Standards Board (FASB) issued Statement No. 13 in 1976, and there have been dozens of modifications and interpretations since. This accounting rule was clearly superior to its predecessors since it required more leases to be capitalized than had been previously.

Capital leases are those leases that in substance are really purchases of the property. The lease contract serves merely as a legal mechanism by which the transaction is effected.

 

In other words, leasing is simply one way of financing the purchase of the piece of property. Accounting for capital leases proves straightforward inasmuch as the property is treated as belonging to the lessee and the liability is considered to be assumed by the lessee. And, managers do not like to show these liabilities, especially when they become huge. So managers expend much time and effort in an attempt to keep these liabilities off the balance sheet.

Actually, we do not have to presume that the leasing activity is de facto a purchase of the leased item. Instead, we could invoke a property rights argument. The essence of this approach is to observe that a lease gives the lessee a right to employ the property any way desired, constrained only by the contract made with the lessor.

The lessee obtains an intangible asset that gives it the right to use certain property for a specified period of time, and this asset should appear on the balance sheet. Likewise the lessee makes a firm commitment to pay for this lease, and this obligation should be recorded on its books.

 

Leases involve transactions that obtain property rights in exchange for a commitment to pay cash for a specified period of time.

 

Lease Accounting – A Little Overview

Accounting for lessees, as stated earlier, breaks down into two categories: either the leases are “operating leases” or they are “capital leases“. We account for operating leases by recognizing a “rental expense” and either a “cash payment or a current liability“.

Accountants treat capital leases in a manner similar to that of a long-term asset by putting an asset on the balance sheet as well as the long-term liability. Periodically, accountants would recognize interest on the long-term liability, and they depreciate the leased asset. On the income statement, we show rental expense for an operating lease versus interest expense plus depreciation for a capital lease. The balance sheet difference is starker—there is no asset or liability for an operating lease, while a capital lease would report a leased asset (less its amortization or depreciation) and a lease obligation.

 

Similarities Of Operating Lease Vs Capital Lease

Let me first demonstrate the similarity between accounting for the purchase of an asset (which is financed by a notes payable or some other financial instrument), AND accounting for a capital lease. Below is an example:

Assume that on January 1, 2003, Lie Dharma Putra Inc. obtains an automobile. In the first case, the corporation buys the automobile and finances it with a car loan. The automobile costs $60,560, has a life of five years, and has a salvage value of zero. The loan calls for five equal annual payments of $15,000, payable at the beginning of the year. (Of course, in practice such loans are typically monthly. The assumption of annual payments greatly reduces the arithmetic but has no impact on the points to be made).

Here are the details of this transaction and its accounting:

We verify the situation by a simple calculation follows:

Lease Accounting

The re-payment schedule would be:

Repayment Schedule

In the business world, a cash payment or receipt first attends to the interest component; any residual amount is then applied to reduce the outstanding balance.

 

The first payment occurs at the very beginning, so there is no interest, and the entire $15,000 reduces the principal, which becomes $60,560 minus $15,000, or $45,560. Interest accrues on this amount, computed with the usual formula I = PRT = $45,560 times 12 percent times one year, for an amount of $5,467. This is added to the balance, making the outstanding debt $51,027. (Alternatively, the accountant may record it as interest payable. The key thing is to note that the full liability includes the principal of $45,560 and the interest of $5,467.) On January 1, 2004, the lessee pays $15,000, which covers the interest and a portion of the principal ($9,533). The balance becomes $36,027, which equals $45,560 minus $9,533. Interest accrues on this to the tune of $4,324, so the outstanding debt at the end of the second year is $40,351. The process continues until the loan is paid off.

Next, let’s compare journal entries as if it is treated as “Purchase Financing” Vs. “Lease Financing”. Here we go:

Comparison of Journal Entries for Purchase Financing vs. Lease Financing

The above figure compares the journal entries for a purchase financed with notes payable versus a capital lease. As can be seen, the entries essentially are the same for all periods. They chronicle the same amount of interest expense and the same amount of depreciation in each of the five years. Further, as panel C shows, they divulge the same amount of total liabilities on the balance sheet. The point is this: “Recording a lease as a capital lease makes it look like a purchase with debt financing of some sort“.

Next, let’s see what happened to the liability on the balance sheet. Here they are:

Liability Effect - Comparison Off Balance Sheet 

On the next section, we will findout the differences. Move on…

 

Differences of Accounting For Capital Lease Vs Operating Lease

Assume that on January 1, Lie Dharma Putra Inc. purchases or leases an automobile for five years from Golan Inc. The car costs $60,560 and will be financed by five annual payments of $15,000, each at the beginning of the year. The interest rate implicit in the lease is 12 percent.

We verify this is the situation by as simple as calculated on the previous section:

Contrast between Capital and Operating Lease

 

And the re-payment schedule would be:

Repayment Schedule - Capital and Operating Lease

Comparison journal entries as if it is treated as Purchase Financing Vs. Lease Financing would be as below:

Comparison Of Journal Entries for Capital Vs Operating Lease

 

And, the liability effect shown below:

Liability Effect - Capital Vs. Operating Lease

The above figures contrast the accounting for a capital lease and an operating lease. The case remains the same, so the repayment schedule is unaffected.

Note: The acute disparity in the bookkeeping and in the effects shown on the income statement and the balance sheet. Treating the lease as an operating lease involves annual rent expense of $15,000 but does not disclose the property rights the corporation has in the lease or any of its financial commitments. As before, treating the lease as a capital lease results in depreciation expense each year of $12,112 and a varying amount of interest expense.

 

Investors and creditors think long-term leases (say, anything over one year in duration) are capital leases for three reasons:

  1. Virtually all long-term leases look like and smell like purchases. There is little difference between them economically speaking.
  2. The lessee possesses significant control over the property during the lease period, and this control is quite similar to the rights an owner of the property has.
  3. When the lessee signs the contract, the entity commits itself to a particular set of cash payments over the life of the lease. This commitment looks like and smells like debt.

 

For these reasons, investors and creditors often argue that all long-term leases should be capitalized.

Above examples helps us to understand why some managers prefer treating long-term leases AS operating leases“.

While the two methods recognize the same total expenses over the life of the lease, the two differ in when they show them:

  • If the lease is recorded as an operating lease, then the firm incurs $75,000 expense over the five years, all of it rental expense of $15,000 annually.
  • If the lease is recorded as a capital lease, the corporation would show depreciation expense of $60,560 (annual amount of $12,112) and interest expense of $14,440, so it too adds up to $75,000. The interest expense declines over time, starting at $5,467 in 2003 and reaching zero in 2007.

 

In other words, capital leases show higher expenses in the early years of the lease and lower expenses in the latter years.

 

Since managers often prefer to show lower expenses in the early years, they prefer operating leases. In addition, because operating leases show no assets on the books, the company will have higher returns on assets. Most important of all, the corporation discloses no liabilities for operating leases, but if it reported a capital lease, it might have to show some large additions to the financial structure of the firm.

When the FASB issued Statement No. 13, it improved financial reporting significantly over what it had been; nonetheless, it still compromised on reporting fully and completely the financial commitments of corporate entities. It invented four criteria for the recognition of a lease as a capital lease. If any one of the following criteria is met, then the business enterprise must account for the lease as a capital lease.

Lease Criteria

For easy reference, here are criteria for a capital lease (any one):

  1. Passage of title to the lessee
  2. Bargain purchase option
  3. Lease term equals or is greater than 75 percent of the useful life of the asset
  4. Present value of the minimum lease payments equals or is greater than 90 percent of the fair value of the property

 

If any one of these criteria is met, then the lease is treated as a capital lease“. If all four criteria fail, then the lease is treated as an “operating lease“.

 

The reason for the first criterion is obvious—a purchase in fact does occur in the future, and there seems no good reason for not recognizing the transaction today. The second concerning an option by the lessee to purchase the property at a very low price is likewise easy to understand. If the lessor, at the end of the lease term, offers the lessee the property at an unreasonably low price, such as $1, then we may assume that the lessee is rational and will exercise the option and purchase the property. This makes the lease a de facto purchase. The third criterion says that if the lessee obtains property rights for most of the life of the property, then the lessee has in essence purchased the item.

The FASB uses as the cutoff 75 percent of the resource’s life. Last, the FASB claims that if the lessee pays virtually the same price as a purchase price, then the transaction by the lessee is equivalent to a purchase. The FASB applies as the cutoff 90 percent of the property’s fair value. Clearly, the two cutoff points are arbitrary, but they serve as a means to classify some leases as capital leases.

Efforts by the FASB to distinguish operating from capital leases have been an improvement over the old rules; however, they serve as fodder for managers to manipulate.

 

EXAMPLE: there are many leases in practice in which the present value of the minimum lease payments is 89.99 percent of the property’s assets values. Certified public accountants (CPAs) and lawyers design the contracts to avoid classification as a capital lease, and in doing so they throw out any sense of decency. While they may meet the technical rules, obviously they have no intention of providing investors and creditors with useful information. More tricks are available, as we shall discover when we look at leases in more depth.

 

Have we got insight of the lease accounting? The answer probably; Not yet! Let’s dive into a more detail explanation.

 

More Insight Into The Lease Accounting

Lease accounting is rich in nuances, so this text cannot investigate every aspect of leases. I shall, however, delve into three major details about lease accounting that illustrate; how lessees can hide debt with lease accounting. These details concern:

  1. The interest rate used to discount the cash flows when performing the 90 percent test
  2. The role of residual values
  3. Contingencies

Let’s go to the details:

[1]. The interest rate used to discount the cash flows when performing the 90 percent test

When a lessor issues a lease, it knows the “fair value of the property” and the “rate of return” required on the investment. Armed with these data, the lessor can then determine the monthly rentals that will generate this rate of return. This rate of return is referred to as the implicit rate of return.

When a lessee signs a contract with the lessor, the lessee may or may not have knowledge of the implicit rate of return embedded in the lease. Because lessees may be ignorant of this rate, the FASB introduces the concept of the borrower’s incremental borrowing rate, which is the rate of interest that the lessee would have incurred to borrow over a similar time period the funds necessary to purchase the property. Then the FASB says that;

  • if the lessee does not know the implicit rate, the lessee will discount the minimum lease payments at the incremental borrowing rate
  • if the lessee does know the implicit rate, then the lessee will discount the minimum lease payments at the lower of the implicit interest rate or the lessee’s incremental borrowing rate.

 

Since lower rates imply higher present values, the consequence of the latter rule is to make it more likely that the 90 percent rule is met.

 

Returning to the example in the previous section, we can re-compute the present values at other interest rates to see what happens. Here is a sample:

Interest RatePresent Value

6%                       $66,976
9%                       $63,596
12%                     $60,560
15%                     $57,825
18%                     $55,351
21%                     $53,107

Now let us think like a manager. Keep in mind that the incremental borrowing rate often is higher than the implicit rate, although not always.

To make the example more concrete, assume that the incremental borrowing rate is 21 percent. If we do not want this lease capitalized, what can we do? The most obvious thing is to tell the lessor that we do not want to know what the implicit rate is (recall that the implicit rate is 12 percent as shown on the two previous sections); in fact, if the lessor tells us, then the deal is off.

Ignorance allows us to discount the cash flows at 21 percent, and this gives us a present value ($53,107) that is only 88 percent of the fair value of $60,560. Voilà! Ignorance allows us to avoid capitalization and not disclose the financial commitment to investors and creditors.

 

[2]. The role of residual values

Like the salvage value used when computing depreciation expense, the residual value is the estimated value of the property at the end of the lease term. These residual values may or may not be guaranteed and un-creatively are termed guaranteed residual values and un-guaranteed residual values. These ideas are relevant to the process because the FASB considers guaranteed residual values part of the minimum lease payments; after all, with the existence of a guaranteed residual value, either the lessee returns the property with a value at or greater than the residual value or it must pay for any deficiencies.

Un-guaranteed residual values, though, never require a payment from the lessee, so the FASB says that they are not part of the minimum lease payments. Suppose we have a lease that has an implicit rate of 12 percent and has $15,000 of annual payments on January 1 of each year for four years with a residual value of $15,000 at the end of the four-year lease term. The fair value again is $60,560, for the lessor expects to receive the residual value, and includes the residual value in its computation of the present value. To the lessee, however, there is a major difference between what happens if the residual is guaranteed or not. If guaranteed, then the present value equals $60,560, which is 100 percent of the fair value, so the lease is capitalized.

If un-guaranteed, then the present value is $51,027, which is only 84 percent of the fair value. The lease is not capitalized. By not guaranteeing the residual value, the lessee unearths yet another way to avoid capitalization and not disclose the financial commitment to investors and creditors.

 

[3]. Contingencies

The third and last detail we shall entertain involves contingencies. Think of a firm that leases floor space in a mall and that has average sales of $1 million per month. Given the nature of the business, the sales are relatively stable from month to month. The lessor wants to charge $50,000 per month for use of the store, but the lessee wants to avoid capitalization of the lease and offers the following counterproposal. The lease will require payment of $10,000 per month plus 4 percent of the sales. According to the accounting rules, contingent rental fees are excluded from the minimum lease payments, so this clause would reduce the minimum lease payment per month from $50,000 to $10,000 and substantially reduce the present value of this stream of cash flows. In this way managers of this business enterprise can avoid reporting its financial commitments from leasing activities.

There are other ways to avoid lease capitalization, but these three ways are dominant and relatively easy to implement. By using the incremental borrowing rate, by not guaranteeing the residual value, and by employing contingent rental fees, a lessee probably can account for the lease as an operating lease.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

13 thoughts on “Hidden Risk Behind The Lease Accounting”

  1. pak putra,,,saya lagi butuh bgt atikel tentang lease back untuk bahan skripsi saya…saya minta tolong informasinya ya…
    thnx b4…

  2. If we enter into a long-term lease for a piece of land with a Public School, and erect communications equipment to provide the School services, can it be classifed as a Capital Lease? We will maintain it and take all risks of ownership, but the Public School is restricted from an actual sale at the end of the lease. How could we structure it to classify it as a Capital Lease?

  3. Karen,

    Pressumably that you have carefully read this post, here are criterion of capital leases:

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

    2.The lessee has the option of buying the asset at a bargain price (“bargain purchase option” or “BPO”) at the end of the lease term.

    3.The present value of the annual annuity of rentals is greater than, or equal to, 90% of the fair market value of the asset at the lease inception date.

    4.The lease term is equal to 75% or more of the asset’s life.

    If any of the above met, then it is a capital lease.

    While I can obviously catch why you are in doubt to treat this transaction as a capital lease “the Public School is restricted from an actual sale at the end of the lease”, let’s try to apply the criterion into your case:

    1st criteria: will the ownership of the land be entitled to you [your organization] at the end of the lease? Obviously, IT WON’T BE.

    2nd criteria: Do you have “bargain purchase option [BPO]”. MOST LIKELY YOU DON’T.

    3rd criteria: is “present value [PV]” of the annual annuity of rentals is greater [or at least equal] 90% of the fair market value at the inception date?, YOU DIDN’T MENTION IT HERE [for good reason]. So check it out youself.

    4rd criteria: is the lease term is equal tp 75% or more of the economic asset’s life? Obviously, LAND HAS NO ECONOMIC LIFE TIME, it is long lasting, so FORGET ABOUT THIS CRITERIA.

  4. Hi Mr. Putra,

    How does the capital lease (both direct finance lease and sale-type lease) record in the balance sheet? Can you show the treatment in the Balance Sheet?

    Thank you. ^^

  5. Grace,

    This is a broad topic. That is why I break all lease accounting into some posts [for lighter page load]. However, you can find them in the related articles [on the top of the right sidebar]. There you can find accounting treatment both on lessor and lessee’s book. For starting you can read this:
    http://accounting-financial-tax.com/2008/09/accounting-for-lease-operating-and-capital-lease/

    And, Continue to articles related to lease accounting 🙂

    After all, if you still have some issues hasn’t be answered yet, feel free to spot questions.

    Happy reading!

  6. two years ago I had classified an operating lease that should be classifed as a capital lease.
    For the two years I just DR Rent expense and Cr Cash. It is a long-term lease, with no bargain purchase and no purchase of property at the end of the lease.
    How should I reverse and how should I make the adjustment entries to fix this could you help?
    Thank you

  7. Hi Putra,

    Interesting overview. I am still unclear on a few things. Say, for example, a company makes BOTH capital and operating leases. Then, the company decides to reclassify everything that was originally a capital lease, into an operating one. How would this effect Net Income and how would it effect Retained Earnings, if at all? Would the amounts changed to these financial line items simply be the original value of the capital leases?

    Looking forward to hearing from you

  8. Hello Putra,

    I have 50 tractors with the total PV at inception classified as a capital lease. One of the tractors was damaged in an accident and lessor received settlement from the insurance company. Should the cost of that one equipment be subtracted from the total cost and adjusted to the asset and obligation, and should the depreciation on the lease be adjusted by the cost or NBV of the equipment ? Thanks for your peedy reply.

  9. Mr. Putra,

    Good afternon! Great information! I’m trying to research a capital lease converting to month-to-month lease (operational lease). Do you have any information. Thanks.

  10. will lessee make any entries in his books when there is a manufacturer or dealer lessor????? cost 35000
    fair value 50000
    implicit rate 10%
    useful life 8 yrs
    UGRV 2000
    kindly provide the entries in the above case of manufacturer lessor…..and amortization schedule will begin from which amount????

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