leasing: research paper

Running head: UNETHICAL PRACTICES IN LEASE ACCOUNTING 1

Unethical practices in lease accounting

Subin Panta

Liberty University

UNETHICAL PRACTICES IN LEASE ACCOUNTING 2

I. Introduction: The unethical practices of lease accounting since the inception of the financial

reporting

II. Body: The problems for lessee and lessor for appropriate allocation of assets and liabilities in

the financial statements.

1. Lease Accounting under GAAP

2. Lease Accounting under IASB

III. Problems arising from lease accounting: The managers used off-balance sheet financing to

hide debt from the balance sheet which makes the company’s financial statements.

IV. Proposed Solution: The proper allocation of assets and liabilities in the balance sheet of the

lessee and the lessor’s financial statement.

V. Ethics in lease accounting: The ethical problems that arose when the company like Enron

collapsed using the off-balance sheet financing.

VI. Conclusions: The new and enhanced financial statements are needed for the allocation for

both the lessee and the lessor.

VII. References


Unethical practices in lease accounting

Lease is not a new word to anyone. People have

leased their house car boat etc. Leasing simple means

lessee owning assets for certain time as per agreement

with lessor without the hassles of actually the owning the

assets. Lease is a widely spread phenomena in today’s

world because of its various benefit but primarily it is for

financial strengthening. Lease and rent are closely

related but lease is a formal rental agreement between the

lessor(the property owner) and lessee(the renter) and

must always hold the term of the contract for the lease to

remain valid whereas rent may not always have a legal

rental agreement. For example if someone is leasing out

his home, he/she may have list of things that he wants his

lessee to follow like how many occupants can live in that

house, how much the monthly rate is, who takes care of

the lawn, whether pets are allowed or not. The landlord

in this case has the right to deny anyone who is not

willing to accept his term. However, if someone is

willing to accept his term a legal contract binds them

together as a lessor and lessee. It is very beneficial for

the lessor because he has a tenant who will take care of

his property according to his terms and also earn monthly


rental money. It’s a win-win situation for the lessor and

the lessee. The lessee is also benefiting from this whole

situation because he/she can enjoy the luxury of the

home without having the burden of owning it especially

in the current state of economy. Majority of people in US

have resorted to leasing out their assets in hope of

financial stability in this dropping economy. It is a lot

wiser and cheaper to lease because one can change or

upgrade when and as needed without having to pay the

full amount at once. As a lessee, you have the freedom

to look for the property that matches your wish list but as

a lessor if you don’t find the right tenant, it will put the

whole burden of paying the monthly mortgage on your

shoulder. However, there are some drawbacks of leasing,

for example if you have to break a lease, it comes with

hefty fine.

Lease Accounting and its importance

In the corporate world, leasing has become very

lucrative method of acquiring property because of its

advantages. It offers 100 percent financing and

protection against wear and tear. It is frequently less

costly than other forms of financing the cost of the

acquisition of fixed assets like real estate properties and


if the lease qualifies as an operating lease, then it doesn’t

add debt to balance sheet. (Schroder et al., 2011)

The financial reporting of the lease has come

long way since the accounting reporting procedure was

required in the US. It is very imperative that both lessee

and lessor get same treatment when comes to taxation

and financial reporting. There are two methods of

allocating lease revenues and expenses to the period

covered in lease agreement: Capital lease which is based

on the view that the lease constitutes an agreement

through which lessor finances the acquisition of assets by

lessee and are in-substance installment purchases pf

assets and operating lease and Operating lease which is

based on the view that the lease constitutes a rental

agreement between the lessor and lessee. (Schroder et al.,

2011)

Even after the accountants came up to two

allocation methods to reporting lease, there are still some

questions remained to be answered like what

characteristic of the lease require to be reported as an in

substance long term purchase of an asset and what

characteristic allow it to be reported as long term rental

agreement. The accounting research bulletin (ARB) no.


28 released the recommendation that if lease are in

substance an installment purchase of property then it

should be reported as an asset and liability. Accounting

principle board (APB) issued Opinion No. 5, “Reporting

of Leases in financial Statement of Lessees”, which

superseded ARB no. 28, explained leases to be

capitalized on the financial statement of lessees. But still

the few leases were capitalized under these provisions.

APB issued three more announcements dealing with

accounting for lessees and lessors. APB Opinion No. 7,

“Accounting for Leases in Financial Statements of

Lessors” which superseded the previously issued

announcement APB Opinion No.5. And then APB

Opinion No. 27, “Accounting for Lease Transactions by

Manufacturers or Dealer Lessors” which supersede the

APB Opinion No. 27 and lastly, APB Opinion No.

31,”Disclosure of Lease Transactions by Lessees” which

superseded APB Opinion No.27. (Schroder et al., 2014)

These entire announcements only confused the

businesses and allowed lessees and lessors to report the

same lease differently. In 1976, after the failure to

develop any kind of symmetry between the reporting of

lease agreement by lessee and lessor, the Financial


Accounting Standard Board (FASB) issued Statement of

Financial Accounting Standards (SFAS) No. 13. SFAC

No.13 superseded all the previously issued

announcements.

The corporate lease accounting has huge impact

on taxation. Schroder et al. (2011) explained that the

companies engaging in lease attempt to transfer the

benefit of owning asset to the lease party in higher tax

bracket. Furthermore they identified eight non-tax

factors that make leasing more attractive than

purchasing:

(i) Short term use relative to overall life of the asset

(ii) Comparative advantage to lessor in reselling the asset.

(iii) Corporate bond covenants of the lessee contain restrictions relating to financial

policies the firm must follow.

(iv) Management contracts contain provisions expressing compensation as a function

of return in invested capital.

(v) Lessee ownership is closely held to reduce risk

(vi) The lessor has market power and can generate higher profit by leasing the asset

than by selling it.

(vii) The asset is not specialized to the firm

(viii) The asset’s value is not sensitive to use or abuse.

Lease accounting under GAAP/FASB


After unsuccessfully trying to answer about the

underlying questions about the lease accounting, the

FASB issued SFAS no 13 “Accounting for Lease” which

superseded previously recommendations by APB and

ARB. SFAS no. 13’s main goal was to establish

standard of financial reporting for both lessee and

lessors. SFAS no. 13 defined lease as an agreement

conveying the right to use property, plant, or equipment

for a stated period of time. However, this statement does

not include agreements that are contracts for services that

do not transfer the right to use property, plant, or

equipment from one contracting party to the other. Also,

this Statement does not apply to lease agreements

concerning the rights to explore for or to exploit natural

resources such as oil, gas, minerals, timber and items

such as motion picture films, plays, manuscripts, patents,

and copyrights. (FASB, 1976) SFAS No. 13 classified

the leases from the standpoint of the lessee and lessor:

Capital lease and operating lease from the view of lessee

and sales-type leases, direct financing leases, leveraged

leases are from the lessor’s viewpoint.

SFAS no. 13(1980) defined the followings are

current criteria for lessee classification as capital lease


under Generally Accepted Accounting Principle

(GAAP):

(i) Ownerships/titles transfers at the end of the lease term; or

(ii) There is a bargain purchase option to buy the leased property at a price

significantly below the expected fair value of the leased property at the end of the

lease term; or

(iii) The term of the lease is equal to or greater than 75% of the estimated economic

life of the leased property; or

(iv) The present value of the minimum lease payments is equal to or greater than 90%

of the fair value of the leased property.

These above mentioned criteria are structured by

FASB for the lessee to treat lease as a capital lease. If the

lease doesn’t fall under any of the above criteria then it is

considered to be the operating lease. Jeter (2006) defined

that in a true operating lease the risk and reward of the

ownership remain with the original owner or lessor. All

the responsibilities like maintenance, taxes, insurance are

lessors; lessee simply rents the asset for some portion of

its useful life. For the lessor to be treat lease as a capital

lease, two more criteria to be met: collectability of the

lease payments and uncertainties regarding lessor

responsibilities. (Jeter, 2006) No matter what the criteria

are, the main concerns regarding the lease accounting is


the appropriate reporting of assets and liabilities in

balance sheet.

SFAC no. 2 defines the qualitative characteristic

of the accounting information. The one quality under the

SFAC no. 2 that can enhance the lease accounting would

be comparability and consistency. It is very important

that the reporting of lease in the financial statements can

be compared from previous years and to other

organization. Seay and Woods (2011) explained that the

objective of the new approach issued jointly by the IASB

and the FASB is to ensure consistencies on lease

accounting across sectors and industries and to improve

quality and comparability of the financial reporting.

Lease accounting under IFRS/IFSB

Under GAAP, there are fewer criteria to meet for

lease accounting than the International Financial

Reporting Standards (IFRS) which was set by its

governing body the International Accounting Standards

Board (IASB). The lease accounting under IFRS has

some requirements that are as similar to the GAAP. For

instance, under IRFS ownership/title transfers at the end

of the lease and there is bargain purchase options at the

end of the lease as well However there are some


differences in the reporting of leases in IRFS. Kilpatrick

and Wilburn (2011) explained that U.S GAAP creates

two all-or-nothing “bright line” tests i.e. a lease term of

75% or more of the asset’s remaining economic life, and

a present value of minimum lease payments of 90% or

more of the asset’s fair value. Under IRFS, these bright

line tests were employed by more judgmental terms like

“major part” and “substantially all” in place of 75% and

90% respectively. According to Kilpatrick and Wilburn

(2011), the following are current criteria for lessee

classification of finance lease:

(i) Ownerships/titles transfers at the end of the lease term; or

(ii) There is a bargain purchase option to buy the leased property at a price

significantly below the expected fair value of the leased property at the end of the

lease term; or

(iii) The term of lease is for a major part of the estimated economic life of the leased

property; or

(iv) The present value of the minimum lease payments amounts to at least

substantially all of the fair value of the leased property; or

(v) The leased asset is of special nature and only the lessee can use the asset without

major modifications; or

(vi) The lessee bears any lessor’s losses associated with lease cancellation; or

(vii) All gains or losses form fluctuation in the residual fair value accrue to the lessee.


Schroder et al. (2011) defined the four principle qualitative characteristics: understandability,

relevance, reliability and comparability. Under IASB, the lease accounting should be consistent

as well as comparable so that users can compare it to past financial statement. The off-balance

sheet financing in the bottom of the balance sheet is very important for investors because it

shows the debt relating to operating lease. If the outstanding debt were not disclosed, the

investors misunderstood and invest and lose significant the money.

Problems arising from lease accounting

Since the APB first announced the reporting

criteria for the lease accounting, the accountants had

some major problems defining the criteria for the

operating lease reporting. There were inaccurate

distinctions between operating and financing leases. The

managers used off-balance sheet financing to hide

substantial debt from balance sheet. It was possible by

the following weaknesses of current lease standards:

i. The current lease accounting standards create knife-edged accounting where small

changes in a transaction can result in either 0 percent or 100 percent of the transaction

reported on the balance sheet.

ii. Under GAAP, the bright line tests determine accounting classifications which managers

used to structure transactions to achieve the accounting treatment they desire.

iii. There is lack of symmetry in the way a transaction is accounted for by the lessee and the

lessor. Having the same transaction reported differently by the two parties to the same

transaction creates lack of comparability and consistency.


iv. There were loopholes created by scope exceptions which management used to defeat the

intent of the standard.

v. The lease standard doesn’t consider executory service contracts and are not reported on

the balance sheet. The management can get around the lease standard by structuring a

lease transaction as a contract for services and not report any debt in the balance sheet.

vi. The management can use renewal terms, options, and contingent payments to get around

the intent of the standard

vii. The management can use special-purpose entities (SPEs) to move leases. (Biondi,

Bloomfield, Glover, Jamal, Ohlson, Penman, S. H., . . . Wilks, 2011).

The main concern amongst the leading researcher

about the lease accounting was its understatement of

assets and liabilities on operating lease, which managers

exploit by putting outstanding debts on off-balance sheet

and not in balance sheet.

Proposed solutions

Given the fact that world are getting smaller and

anyone can do business anywhere, it is very imperative

that there is one concept for the financial standards.

FASB and IFRS are working together on projects to

develop the framework for financial reporting standards

that will be used globally. The benefit would be

abundant for the US firms as well as other firms who

want to do business in the US. Let’s say the X Company


from the US wants to lease a factory building in the

Europe. Then how would the lessor in the Europe report

the leasing activities on their financial statements and

how the lessee the X firm would report the leasing

activities in theirs.

There were lots of researches done to define the

issues associated with accounting by lessees; few studies

have focused on lessors. Bauman & Francis (2011) tried

to address the gap and studied financial statement

disclosures of 57 of the 100 largest equipment lessors in

the U.S. market to examine key reporting and disclosure

issues, and suggest improvements that could be

incorporated into pending lease accounting guidance.

Furthermore they found that the balance sheet effects

associated with formal recognition of operating leases

are generally not material and the recognition of a

performance obligation liability raises the possibility of

increased book leverage, expected increases in the

liabilities-to-assets ratio are minimal.

On august 2010, FASB and IASB jointly issued

exposure drafts proposing a new accounting paradigm

for leases. Seay and Woods (2011) outlined the core

proposals for lessees and lessors accounts for all leases


by application of a right-of-use model where assets and

liabilities recognized by lessees and lessors would be

measured on following assumptions: the longest possible

lease term more likely than not to occur, considering

renewal and termination options, determination of lease

payments on an expected outcome basis and

asset/liability valuation will be reassessed each reporting

period to reflect significant changes.

The proposed solution for the lease accounting

would be greater transparency. The off-balance sheet

financing should be clearly stated in balance sheet so that

the investors and shareholders can know of any debts.

Sealy and woods (2011) outlines on their paper the

proposed solution of the lease accountings are: new lease

accounting model to reflect all lease contract assets and

liabilities, greater transparency, consistent lease

accounting, substance over form; comparability

enhanced and reduced structuring opportunities

When the lessee dies, the lease agreement voids

and the lessor control the property. Another major point

that I think that need to be clarified is what happened to

lease agreement if the lessor dies without the appropriate

will or no on inherit it.


Ethics in Lease Accounting

If a lease agreement was operating lease, it’s not

reported as long term debt in balance sheet, so the lessee

can put it in off-balance-sheet financing. The reporting

for off-balance sheet is that you add the line in separate

to shoe off balance sheet financing. Lots of managers

like to use off-balance sheet financing to improve the

financial position of the companies in the financial

statements. One of the major financial disasters comes

from the use of off-balance sheet financing. Enron used

off-sheet balancing of leases without disclosing it in

footnotes in balance sheet. Jeter (2006) explained that

firms seeking additional financing or expecting to need

loan in futures usually keep debt off balance sheet. The

author provided the example of Enron who kept

enormous amounts of debt off balance sheet by

combination of acceptable and unacceptable techniques.

After the Enron, Securities and Exchange

commission (SEC) and the FASB vows to change the

reporting standards regarding off –balance sheet

financing. It looks like that still some of the major

companies still used these tactics. Weil (2004) gave

some examples of how the multi-national companies are


using off-balance sheet without contemplating the result

it will have in the economy. For example:- US Airways

Group Inc., didn’t show $7.39 billion in operating lease

commitment it had on its fleet of passenger jets,

drugstore chain Walgreen Co. is responsible for $19.3

billion of operating-lease payments mainly on stores over

the next 25 years but has no debts shown in the balance

sheet. The popularity of off-balance sheet is so much that

the companies in the Standard &Poor’s 500-stock index

show total $482 billion as operating-lease commitments

in the footnotes to their financial statements. (Weil,

2004)

We all know that Enron’s crash was blamed on

the off-balance sheet financing. It gave bad name to lease

accounting. But according to the report printed in

financial watch, Enron used partnership called Special

Purpose Entities (SPEs) which was owned by third

parties to do their leasing of the assets and to keep assets

and liabilities off books. Enron didn’t disclose existence

of the SPEs nor consolidate them. (Using “Enron

Accounting”, 2002) It was unethical as an accountant or

CPA of Enron, to use off-balance sheet financing in the

veil of operating lease commitments. Sure, the financial


statements of the corporation looks better but this hiding

of debt off the financial statement could have serious

impact on the corporation. In this case, it collapsed

Enron and financial and emotional ruin for its investor

and shareholders. After such an abuse of accounting

from companies like Enron, WorldCom, the quality of

the financial statement need to be enhanced significantly

in the future. Then Sarbanes-Oxley Act was created

which required that company official to sign off on the

financial statements, the establishment of the Public

Company Accounting Oversight Board (PCAOB) and

strengthen independence for the public accounting firm,

board audit committee and the internal control.

Conclusions

Because of the failures of Enron and WorldCom,

lease accounting is getting all the bad names. Specially

operating lease and the provision of off-balance sheet

leasing. Managers use this method to hide the substantial

amounts from book to make financial statement more

desirable to the users. But the outcome of using off-

balance sheet methods can be devastating. So it is very

imperative that the governing bodies like the FASB and

IFRS should develop a uniform disclosures framework to


be used by all the firms to simplify the financial

statements. But there are rooms to improve in the lease

accounting. When the giant corporations like Enron,

WorldCom collapsed, the public lost their trust in the

accounting. The transparent and comparable financial

statements are needed to gain the trust of the investors,

creditors and the public. The joint collaboration of the

IASB and the FASB are working on to establish the

conceptual framework for one standard financial

reporting. The stakes are too high to neglect the impact

of the lease accounting in the economy.

Even in the verse 6:7-8 of Galatians, God has

warned us saying that “Do not to be deceived: God is not

mocked, for whatever one sows, that will he also reap.

For the one who sows to his own flesh will from the

flesh reap corruption, but the one who sows to the Spirit

will from the Spirit reap eternal life.” The falsifying

financial record caused the ruin for Enron.

.


References

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