![Page 1: Operating Lease Obligations to Be Capitalized](https://reader036.vdocuments.us/reader036/viewer/2022082519/5695d00b1a28ab9b0290b3dd/html5/thumbnails/1.jpg)
Operating Lease Obligations to be Capitalized
Wow! I have wondered for a few decades whether the accounting profession ever
would account for operating leases correctly. Long-term operating leases, as opposed
to rentals no longer than one year, clearly convey property rights and encumber the
business entity with debt obligations. Not to require this accounting has served as a
badge of hypocrisy long enough.
The FASB and the IASB issued exposure drafts August 17, which propose to make
this change in the treatment of operating leases. They also discuss some changes in
the accounting for purchase options, conditionals, leases with service contracts, and
the accounting for lessors, including the elimination of leveraged leases. I shall
address these topics at a later time; in this essay I wish to concentrate on the more
fundamental issue of lessee accounting.
Let’s review the history of accounting for operating leases briefly. The board issued
Statement No. 13 on lease accounting in November 1976. (The Accounting
Principles Board also had pronouncements on lease accounting, but they were simply
dreadful.) For lessees, the statement created two categories, capital leases and
operating leases. The FASB concocted 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. They are: (a) if legal title passes to the
lessee; (b) if the lease contains a bargain purchase option; (c) if the lease term (the
length of the lease) equals or exceeds 75 percent of the asset’s life; and (d) if the
present value of the minimum lease payments equals or exceeds 90 percent of the fair
value of the leased property. If none of the four criteria is met, then the business
enterprise treats the lease as an operating lease.
Accounting for these leases differs greatly. In a capital lease, the firm capitalizes the
asset at its present value (not to exceed its fair value), and it capitalizes the lease
obligation at the present value of future cash flows. On the income statement, the
business enterprise shows the depreciation of the capitalized asset and displays the
interest expense on the lease obligation. In an operating lease, the entity ignores its
property rights and it pretends that it has no debts, and on the income statement, the
![Page 2: Operating Lease Obligations to Be Capitalized](https://reader036.vdocuments.us/reader036/viewer/2022082519/5695d00b1a28ab9b0290b3dd/html5/thumbnails/2.jpg)
organization acknowledges a rent expense. There is, however, no economic
justification for this differential treatment.
I think it amazing—maybe even revolutionary—for the board finally to follow its own
conceptual framework in the development of lessee accounting standards. The
FASB’s conceptual framework defines assets as “probable future economic benefits
obtained or controlled by a particular entity as a result of past transactions or events.”
Further, it defines liabilities as “probable future sacrifices of economic benefits
arising from present obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past transactions or events.”
It doesn’t take an accounting professor, much less Donald Trump, to figure out that
leases confer to lessees probable future economic benefits and probable future
sacrifices. Present-day accounting for operating leases contradicts this rational
approach of reporting the economics of these business transactions. If the board only
applies its own conceptual framework, as it appears ready to do, then it will achieve a
much better accounting.
Let’s also remind ourselves of the significant consequences of these actions. Billions,
maybe trillions, of dollars of lease obligations have been off-balance sheet since time
began. Here is a small sample of firms, with my estimates (details on my estimation
scheme in “Hidden Financial Risk”) of the present value of the cash flows
of the operating leases (numbers are millions of dollars except for
percentages).
Reported
Debt
PV of Operating Lease
Cash Flows
Percent Debt is Under-
reported
CVS 25,873 26,913 104.02%
Walgreens 10,766 23,212 215.60%
McDonalds 16,191 7,996 49.39%
Target 29,186 2,155 7.38%
Home
Depot21,484 5,846 27.21%
Starbucks 2,532 3,685 145.54%
![Page 3: Operating Lease Obligations to Be Capitalized](https://reader036.vdocuments.us/reader036/viewer/2022082519/5695d00b1a28ab9b0290b3dd/html5/thumbnails/3.jpg)
Clearly, the capitalization of essentially all leases is an important step to knowing
realistically what corporations owe. Notice that this sample of only six firms has off-
balance sheet lease debts of almost $70 billion. As this amount is material to
everybody (except for members of Congress and the White House), business
enterprises should supply this information to investors and creditors so they can better
understand the firm’s financial leverage.
While this chapter of financial reporting is coming to a close, the most remarkable
event in the history of lease accounting occurred in 1960. That year Arthur Andersen
published the booklet “The Postulate of Accounting” and averred that the only
postulate of accounting is fairness. “Financial statements cannot be so prepared as to
favor the interests of any one segment without doing injustice to others.” To add flesh
to this argument, Arthur Andersen then gave the example of leases, contending that
all leases should be capitalized. Unfortunately, the AICPA’s Committee on
Accounting Procedure and its Accounting Principles Board ignored these comments.
Fifty years ago this once great firm, under the leadership of Leonard Spacek, showed
how a principled and courageous analysis of the facts could lead one to the proper
accounting. It shows that principles-based accounting can work—as long as we have
principled leaders in the profession. But it also shows the dangers of principles-based
accounting when others are not blessed with logical thinking or courage—when they
are not principled.
P.S. The FASB really doesn’t have to apply an exception to short-term leases, those
under twelve months in duration. Every FASB statement is stamped with the caveat,
“The provisions of this Statement need not be applied to immaterial items.” As I
expect most short-term rentals to provide income statement and balance sheet effects
that are immaterially different from their capitalization, there is already a basis for
firms not to worry about the accounting for such leases.