Table 261

Leasing and the Balance Sheet disclose the existence of the lease contract on the balance sheet. Lessees had to report information on leasing activity only in the footnotes to their financial statements.

In November 1976, the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 13 (FASB 13), "Accounting for Leases." The basic idea of FASB 13 is that certain financial leases must be "capitalized." Essentially, this requirement means that the present value of the lease payments must be calculated and reported along with debt and other liabilities on the right-hand side of the lessee's balance sheet. The same amount must be shown as the capitalized value of leased assets on the left-hand side of the balance sheet. Operating leases are not disclosed on the balance sheet. Exactly what constitutes a financial or operating lease for accounting purposes will be discussed in just a moment.

The accounting implications of FASB 13 are illustrated in Table 26.1. Imagine a firm that has $100,000 in assets and no debt, which implies that the equity is also $100,000. The firm needs a truck costing $100,000 (it's a big truck) that it can lease or buy. The top of the table shows the balance sheet assuming that the firm borrows the money and buys the truck.

If the firm leases the truck, then one of two things will happen. If the lease is an operating lease, then the balance sheet will look like the one in Part B of the table. In this case, neither the asset (the truck) nor the liability (the present value of the lease payments) appears. If the lease is a capital lease, then the balance sheet will look more like the one in Part C of the table, where the truck is shown as an asset and the present value of the lease payments is shown as a liability.4

4In Part C, we have made the simplifying assumption that the present value of the lease payments under the capital lease is equal to the cost of the truck. In general, the lessee must report the lesser of the present value of the lease payment stream or the cost of the equipment under lease.

Ross et al.: Fundamentals VIII. Topics in Corporate 26. Leasing of Corporate Finance, Sixth Finance Edition, Alternate Edition

878 PART EIGHT Topics in Corporate Finance

As we discussed earlier, it is difficult, if not impossible, to give a precise definition of what constitutes a financial lease or an operating lease. For accounting purposes, a lease is declared to be a capital lease, and must therefore be disclosed on the balance sheet, if at least one of the following criteria is met:

1. The lease transfers ownership of the property to the lessee by the end of the term of the lease.

2. The lessee can purchase the asset at a price below fair market value (bargain purchase price option) when the lease expires.

3. The lease term is 75 percent or more of the estimated economic life of the asset.

4. The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease.

If one or more of the four criteria are met, the lease is a capital lease; otherwise, it is an operating lease for accounting purposes.

A firm might be tempted to try and "cook the books" by taking advantage of the somewhat arbitrary distinction between operating leases and capital leases. Suppose a trucking firm wants to lease a $100,000 truck. The truck is expected to last for 15 years. A (perhaps unethical) financial manager could try to negotiate a lease contract for 10 years with lease payments having a present value of $89,000. These terms would get around Criteria 3 and 4. If Criteria 1 and 2 were similarly circumvented, the arrangement would be an operating lease and would not show up on the balance sheet.

There are several alleged benefits from "hiding" financial leases. One of the advantages of keeping leases off the balance sheet has to do with fooling financial analysts, creditors, and investors. The idea is that if leases are not on the balance sheet, they will not be noticed.

Financial managers who devote substantial effort to keeping leases off the balance sheet are probably wasting time. Of course, if leases are not on the balance sheet, traditional measures of financial leverage, such as the ratio of total debt to total assets, will understate the true degree of financial leverage. As a consequence, the balance sheet will appear "stronger" than it really is. But it seems unlikely that this type of manipulation would mislead many people.

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