Mackenzie Wolfgram: Capital Lease Accounting is Honest Accounting. Operating Lease Accounting is Not

I am pleased to host another student guest post, this time by Mackenzie Wolfgram. This is the 15th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link. This is Mackenzie’s second guest post. His first was “Why the $15 Minimum Wage is Bad for the Poor.”

To fully understand this post, it is helpful to read the definitions of “Capital Lease” and “Operating Lease” on Investopedia.

Itay Kama, one of my accounting professors at the University of Michigan would always tell us, “the main goal of a company’s financial accounting should always be to reflect their economic reality as accurately as possible.” One would hope that companies would take this to heart and make the effort to be as forthright with the public as they could be without regulation forcing them to do, but this is not always the case, and currently one area that the FASB’s standards are being used improperly is the way in which leases are recognized on the balance sheet. Namely, operating leases are reported in a way that allows companies to artificially boost their ratios, especially revenue/assets, and attempt to mislead investors. Luckily for us, changes appear to be underway.

There are two ways that a lease can be documented, as a capital lease, or an operating lease. A capital lease takes into account all of the payments that will take place during the entire lease and shows the present value of these payments as a long term liability, in contrast with this liability the value of the lease to the company is represented as an asset. These balances are depreciated/expensed over the term of the lease in order to reflect the value of remaining lease term, and the amount owed in the future. An operating lease is on the other end of the spectrum as far as recognition of liabilities and assets, as there is absolutely no recognition of either. Under an operating lease, each year, you will see a credit to cash and a debit to rental expense for the amount that was paid into the lease that year. That is the only recognition that makes its way onto the balance sheet. Even though in the economic reality the company has a liability to pay that same amount for the next X amount of years, there is no admission of this, nor is there any recognition of the assets that the company has the right to use over the life of the lease. This allows companies to have a considerable amount of off balance sheet activity, including the potential to hide both debt and assets.

Since the Operating Lease method of accounting does not recognize either liabilities or assets from leases, companies vastly prefer operating leases to capital leases. The main reason is that it allows for liabilities to be kept off the books, which makes the company look better since it doesn’t appear that they are indebted heavily to those that they have leased assets form. Although these companies are contractually obligated to pay large amounts of money into the lease each year, they are able to hide this under the operating lease structure. The Wall Street Journal (Michael Rapoport) estimates that if this accounting standard is changed, American companies will have to recognize an additional $2 trillion in leases. This method is also preferred since it helps the revenue/assets ratio. The higher this ratio, the more revenue a company earns from each dollar invested in assets. When this ratio is high, the company is perceived as being more efficient and capable of utilizing assets in a more profitable way than a company with a lower revenue/assets ratio, or asset turnover ratio.

Clearly, managers are hugely incentivized to recognize leased assets under the operating structure. As long as they are able to avoid breaking any of the following rules, then a lease is an operating lease. A capital lease must be used only if:

Ownership. The ownership of the asset is shifted from the lessor to the lessee by the end of the lease period; or
Bargain purchase option. The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
Lease term. The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is noncancellable during that time); or
Present value. The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.

Clearly, it is very easy to qualify for the operating lease structure.

This method of accounting reflects reality poorly when compared to the capital leases, and companies don’t even get much advantage out of it in the end. Although household investors and smaller operations may take the warped word of the balance sheet, every single credit rating agency, major brokerage, and investment agency is going to go into the footnotes and find out how the true value of their capital leases. Since this information is required to be included in the footnotes of the report, yet can be hidden on the balance sheet as long as they qualify for a capital lease. The only people who are truly disadvantaged by this system are those less sophisticated investors who don’t have a professional grade grasp of accounting standards and their implications. For these reasons, FASB Chairman Russell Golden is hopeful that the standards will change, this “will give investors, lenders and others a more accurate picture of the financial condition of the companies to which they provide capital.” In addition to being more accurate, recognizing leases fully will allow companies to depreciate the value of the lease, which will give them a boosted tax shield.

In the interest of forthright accounting, an area that is complicated enough already, I truly hope that this new standards goes through. Unfortunately, when large companies have the potential to lose a lot of money, things tend to be tricky to change. This new rule has already been proposed twice, and shot down both times. Yet I remain hopeful that this will be the time that we are able to pull the trigger on making accounting more honest.