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

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%

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.