Capturing the benefits of operating and synthetic leases

Abstract

Here's an important leasing strategy that CEOs, CFOs, and treasurers should know about. By applying constructive lease capitalization on the operating leases of several firms, the authors show that companies can hide many liabilities from financial reporting. And they can also enhance net income, retained earnings, and key financial ratios-all by reporting leases as operating leases instead of capital leases. (or SPE) to be consolidated if a higher minimum equity investment (from 3 percent of total assets to 10 percent or more for VIEs with risky assets) is not obtained, among other conditions. As a result, not only has there been a dramatic reduction in the number of new synthetic leases, but we also have seen a significant decline in the total number of preexisting synthetic leases (i.e., by unwinding the synthetic leases) to avoid the consolidation of the assets and liabilities of its SPE ("FASB Regulations Change SPE Treatment," 2002;Kaikati, 2004).Despite this decreased availability of synthetic leases, firms can still hide billions of dollars' worth of lease obligations from financial statements by structuring leases as operating leases. For example, Statement of Financial Accounting Standard (SFAS) No. 13 (Accounting for Leases) allows companies to report leases as operating leases (and thus avoid reporting lease liabilities) if, among other criteria, the present value of future lease payments is less than 90 percent of the fair value of the leased asset. Therefore, a company can ensure an operating lease status by structuring the present value of lease payments to equal to 89.99 percent or less of the fair value of the lease asset, thereby ensuring that neither lease liability nor asset is reported. In contrast, had the lease met the 90 percent rule, or another of the capital lease criteria, the lease liability and asset would be reported on the balance sheet, as well as interest and depreciation expense, on the income statement. Thus, when a company obtains an asset via a lease arrangement, it can report significantly different financial statements with only a slight difference in the lease contract (i.e., 0.01 percent of the fair value of the lease asset).Due to these rule-based accounting standards for leases, companies can and have continued to rely on operating leases to hide significant amounts of liabilities even in the post-Enron era. As an example, a Wall Street Journal (WSJ) article (Weil, 2004) identified six firms as major users of operating leases in the post-Enron era (i.e., 2003). Although the article was quite informative, it provided limited lease-related financial information (i.e., only the undiscounted future lease payments). The purpose of this article is to assume that the operating leases of these six firms were instead reported as capital leases (i.e., applying constructive lease capitalization on these firms' operating leases) and study the impact of this constructive lease capitalization on key financial numbers such as unrecorded lease assets, unrecorded lease liabilities, ...

Canadian Evidence on the Constructive Capitalization of Operating Leases*

“…This would apply to all industry segments, with the least effects evident in oil and gas (O&G) and utilities with regard to the unrecorded current liability. The Canadian evidence in this study therefore contributes to the literature reporting a large unrecognized liability related to operating leases for companies in the United States (Duke and Hsieh, 2006;Gosman and Hanson, 2000;Gritta et al, 1994;Imhoff et al, 1993;Imhoff et al, 1991), the United Kingdom (Beattie et al, 1998;Goodacre, 2003), and New Zealand (Bennett and Bradbury, 2003). To capitalize operating leases, rental expense is replaced by amortization and interest expenses, which affects income and management performance and investment return indicators.…”

“…the leverage ratios of 30 sample firms exceeded 50 percent, with 10 firms reporting over 75 percent. Duke and Hsieh (2006) used Imhoff et al's (1991Imhoff et al's ( , 1997 assumptions to compute the effect of capitalizing the operating leases of six U.S. firms that The Wall Street Journal identified as significant users of off-balance-sheet lease liabilities. Assuming a uniform 10 percent interest rate, a remaining life of 15 years, and an unamortized asset of 70 percent of unrecorded liability, they calculated a mean off-balance-sheet liability of 89.5 percent of total unadjusted liabilities and a mean unrecorded asset of 39.4 percent of total unadjusted assets.…”

Proposed Changes in Lease Accounting and Private Business Bankers' Credit Decisions*

“…Whereas the significant impact of the G4+1 recommendations has already been documented for large companies in the United States (Duke and Hsieh, 2006;Gosman and Hanson, 2000;Gritta, Lippman, and Chow, 1994;Wright, 1991, 1997), the United Kingdom (Beattie, Edwards, and Goodacre, 1998;Goodacre, 2003), Germany (Fülbier, Silva, and Pferdehirt, 2008), New Zealand (Bennett and Bradbury, 2003), and Canada (Durocher, 2008;Lanfranconi and Wiedman, 2000), to our knowledge, no one has investigated the impact on private companies' financial statements.…”

“…Previous authors who studied the impact of the capitalization of operating leases can be divided into two groups, those who used simplified assumptions to restate reported figures (Gosman and Hanson, 2000;Gritta et al, 1994;Lanfranconi and Wiedman, 2000), and those who used an extensive constructive capitalization methodology (Beattie et al, 1998;Bennett and Bradbury, 2003;Duke and Hsieh, 2006;Durocher, 2008;Fülbier et al, 2008;Goodacre, 2003;Imhoff et al, 1991Imhoff et al, , 1997. The use of an extensive capitalization methodology requires information on the present value of minimum lease payments at the end of the current and previous periods in order to estimate the effect on income, based on the variation of the effect on shareholders' equity.…”

Impact of New Standard "IFRS 16 Leases" on Statement of Financial Position and Key Ratios: A Case Study on an Airline Company in Turkey

“…Duke and Hsieh (2006) have used the assumptions taking place in the studies of Imhoff et.al. (1991Imhoff et.al.…”