PricewaterhouseCoopers Survey

Financial Statement Impact of Changes in Lease Accounting Standards


Table of Contents:

List of Tables

Executive Summary

Financial Statement Impact of Changes in Lease Accounting Standards
In its Statement of Financial Accounting Standards No. 13, Accounting for Leases (FAS 13), the Financial Accounting Standards Board (FASB) established standards of financial accounting and reporting for leases by lessees and lessors. Concerns have been raised whether these current financial reporting standards are adequate for distinguishing between capital and operating leases. Some observers believe that financial arrangements have been structured to meet the conditions for classification as an operating lease that properly should be accounted for as a capital lease. If capital leases are inappropriately characterized as operating leases, a company may avoid the effects of capitalization on financial statement ratios. In addition, it has been observed that the off-balance-sheet effects of operating leases may be too material to ignore for meaningful analyses and comparisons of financial statement data.

As a consequence of such concerns, the Financial Accounting Standards Board (FASB) published, in July 1996, a Special Report entitled Accounting for Leases: A New Approach-Recognition by Lessees of Assets and Liabilities Arising Under Lease Contracts. This report was developed by the G4+1 Group, which consists of representatives of the standards-setting boards of Australia, Canada, New Zealand, the United Kingdom, the United States, and the International Accounting Standards Committee (IASC). The report proposed a new standard for lease accounting under which lessees would be required to capitalize all non-cancelable leases with an initial duration of more than one year.

To better understand the impact of the G4+1 proposal, the Equipment Leasing Association (ELA) asked PricewaterhouseCoopers (PwC) to measure the long-run impact on a lessee's financial statement of the G4+1 proposal compared to current financial accounting standards. This study quantifies the impact of the G4+1 proposal using non-public data on operating lease terms obtained on a confidential basis from participating firms. Data for the analysis was obtained though a survey ("PricewaterhouseCoopers Survey of Operating Leases") sent to lessees. PwC contacted twelve companies initially identified by ELA member companies. Four companies agreed to participate and provided operating lease data to PwC.

The survey requested the following data for all operating leases with an initial lease term of more than one year that were still in effect at the close of 1998:

  1. The date of lease inception.
  2. The lease term.
  3. The lease payment schedule.
  4. The interest rate used in classifying the lease as an operating lease.

Based on the survey information provided, PwC adjusted the income statement and the balance sheet of each company in accordance with the G4+1 proposal. The adjustments were based on the survey data and not on other data disclosed in public financial statements.

Table 1 shows the income statement adjustments as a percent of each company's net income for the year ending December 31, 1998. Pre-tax income was adjusted by: (i) reversing the deduction for rental payments attributable to capitalized operating leases, (ii) adding a deduction for amortization of capitalized operating leases, and (iii) adding a deduction for interest attributable to capitalized lease obligations. In the case of Company 1, which reported a loss for 1998, the standards proposed in the G4+1 Special Report would have increased its loss by approximately 23 percent. Company 2, which also reported a loss for the year, would likewise have had a 3 percent greater loss than the company actually reported. Net income reported by Company 3 and Company 4 would have been lower by approximately 3.5 percent and 2.3 percent, respectively.

Table 1

Impact of the G4+1 Proposal on Net Income

(in thousands of dollars, except where noted;

negative amounts in parentheses)

Company

Net Change

in Income

Net Income (Loss) for Year Ended 12/31/98

Impact on Net Income

(% change)

Company 1

($1,056)

($4,678)

(22.6%) *

Company 2

($597)

($19,857)

(3.0%) *

Company 3

($439)

$12,654

(3.5%)

Company 4

($26,704)

$1,155,000

(2.3%)

* Percent increase in reported loss.

Table 2 shows the balance sheet adjustments as a percent of each company's assets, liabilities, and net worth as of December 31, 1998. Assets and liabilities on the balance sheet were adjusted by including the capitalized value of operating lease obligations under the rules for capital leases in FAS 13. This affects a company's net property and equipment on the asset-side and its entries for current maturities of long-term debt and long-term debt on the liability-side of the balance sheet. Had the G4+1 proposal's standard for lease accounting been followed, all four companies would have reported a greater amount of assets. The increases ranged from 4.5 percent to 18.5 percent. The reported level of liabilities under the G4+1 proposal would have also increased relative to the liabilities actually reported. These increases ranged from just over 8 percent to approximately 16 percent. In all four cases, net worth reported on the balance sheet would have shown a decline. The magnitude of the declines relative to each company's reported net worth ranged from 0.2 percent to 4.3 percent.

Table 2

Impact of the G4+1 Proposal on Assets, Liabilities and Net Worth

(in thousands of dollars, except where noted;

negative amounts in parentheses)

Assets

Company

Total Change

in Assets

Assets as of 12/31/98

Impact on Assets

(% change)

Company 1

$43,452

$235,087

18.5%

Company 2

$19,907

$285,914

7.0%

Company 3

$63,508

$1,075,812

5.9%

Company 4

$1,029,397

$22,690,000

4.5%

Liabilities

Company

Total Change

in Liabilities

Liabilities as of 12/31/98

Impact on Liabilities

(% change)

Company 1

$45,364

$279,227

16.2%

Company 2

$20,838

$168,644

12.4%

Company 3

$63,947

$793,582

8.1%

Company 4

$1,216,633

$14,920,000

8.2%

Net Worth

Company

Total Change

in Net Worth

Net Worth (Deficit) as of 12/31/98

Impact on

Net Worth

(% change)

Company 1

($1,912)

($44,140)

(4.3%) *

Company 2

($931)

$117,270

(0.8%)

Company 3

($439)

$282,230

(0.2%)

Company 4

($187,236)

$7,770,000

(2.4%)

* Percent increase in net worth deficit.

In summary, had the four companies included in the analysis accounted for operating leases as proposed in the G4+1 Special Report, there would have an adverse impact on their financial statements. In all four cases, both net income and net worth would be lower than that reported under current financial accounting standards. For the sample of firms that participated in this study, the financial statement impact of the G4+1 proposal was largest, in percentage terms, for the company with the weakest balance sheet.

Top top

I. Introduction
This report summarizes a study of the potential impact of proposed changes in operating lease accounting standards on lessee company financial statements. PricewaterhouseCoopers (PwC) prepared the study for the Equipment Leasing Association (ELA). Section II of this report provides background information on the current accounting treatment of operating leases and a proposal to change that treatment developed for the International Accounting Standards Committee (IASC).1 Section III describes the study's analytical approach. Section IV presents the results of the analysis for those companies responding to PwC's survey.

Top top

II. Background
In its Statement of Financial Accounting Standards No. 13, Accounting for Leases (FAS 13), the Financial Accounting Standards Board (FASB) established standards of financial accounting and reporting for leases by lessees and lessors. From the standpoint of a lessee, leases are classified as either capital leases or operating leases. An operating lease is any lease that does not meet any of the four criteria used to define a capital lease, and a capital lease is one that meets one or more of these four criteria:2

  1. The lease transfers ownership of the property to the lessee by the end of the lease term.
  2. The lease contains a bargain purchase option.
  3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
  4. The present value, at the beginning of the lease term, of the minimum lease payments, excluding that portion of the payments representing executory costs, to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him.

A lessee is required to record a capital lease as an asset and an obligation.3 In the case of operating leases, neither an asset nor an obligation is reported. Instead, rental payments are recorded as rental expense in the income statement.4

Concerns have been raised whether current financial reporting standards are adequate for distinguishing between capital and operating leases. Since current accounting standards do not require a lessee to recognize as assets and liabilities the rights and obligations arising under operating leases, some observers believe that financial arrangements have been structured in order to meet the conditions for classification as an operating lease.5 If capital leases are inappropriately characterized as operating leases, a company may avoid the effects of capitalization on financial statement ratios.6 In addition, it has been observed that the off-balance-sheet effects of operating leases "are simply too material to ignore for meaningful analyses and comparisons of financial statement data."7

As a consequence of such concerns, the Financial Accounting Standards Board (FASB) published, in July 1996, a Special Report entitled Accounting for Leases: A New Approach-Recognition by Lessees of Assets and Liabilities Arising Under Lease Contracts (the "G4+1 Special Report").8 The G4+1 Group, which consists of representatives of the standards-setting boards of Australia, Canada, New Zealand, the United Kingdom, the United States, and the International Accounting Standards Committee (IASC), developed this report. The report proposed a new standard for lease accounting under which lessees would be required to capitalize all non-cancelable leases with an initial duration of more than one year.

Top top

III. Analytical Approach
The primary objective of this study is to measure the long-run impact on a lessee's financial statement of the G4+1 proposal compared to current financial accounting standards. Specifically, using data provided by several lessees, the report quantifies how each company's income statement and balance sheet would differ from that included in its 10-K for 1998. The analysis assumed that the G4+1 method had applied historically to all operating leases in effect at the close of 1998.9

Top top

A. PwC Survey of Operating Leases
This study uses non-public data on operating lease terms obtained on a confidential basis from participating firms, rather than the publicly available company financial data in the Standard & Poor's Compustat database. Data for the analysis was obtained though a survey ("PricewaterhouseCoopers Survey of Operating Leases") sent to lessees.10 ELA member companies initially identified a total of twelve potential survey participants. PwC contacted these companies and sent them the set of survey materials. Four companies provided operating lease data to PwC. The other companies, for various reasons, chose not to participate.

The survey requested the following data for all operating leases with an initial lease term of more than one year that were still in effect at the close of 1998:

  • The date of lease inception.
  • The lease term.
  • The lease payment schedule.
  • The interest rate used in classifying the lease as an operating lease.

The definitions of these items are based on FAS 13:

  • The lease term includes all periods covered by bargain renewal options or where renewal is reasonably assured due to penalties imposed for failure to renew. [FAS 13, ¶ 5(f)]
  • The lease payment schedule includes the date at which payments are due and the minimum lease payment. The minimum lease payment includes any guarantee by the lessee of the residual value at the conclusion of the lease or penalties for failure to renew. [FAS 13, ¶ 5(j)]
  • The interest rate is generally the lessee's incremental borrowing rate at lease inception unless the lessee can learn the discount rate implicit in the lease computed by the lessor and this rate is less than the incremental borrowing rate. [FAS 13, ¶ 7(d)]

The four participating companies represented the following industries:

  • dredging and marine construction,
  • operation and management of outpatient diagnostic imaging centers,
  • equipment rental, and
  • transportation services.

The company in the dredging and marine construction business provided information on eight pieces of leased equipment. The equipment included dredges, scows, and a crane. The lease term for this equipment ranged from eight to eleven years. The monthly lease payments ranged from approximately $10,000 to nearly $200,000.

The company involved in the operation and management of outpatient diagnostic imaging centers provided leased equipment information for forty-four pieces of equipment. The company did not describe the specific types of equipment leased. For nearly all of the leases reported, the lease term was five years. The monthly lease payments ranged from a few hundred dollars to approximately $40,000.

The equipment rental company reported information for thirty-four pieces of equipment, but did not describe the specific types of equipment. The leases generally had a term of five years. Quarterly lease payments ranged from approximately $12,000 to $250,000.

The transportation services firm provided lease information for over 100 leases including locomotives and boxcars. These leases had terms ranging in length from just under five years to twenty-three years. Annual lease payments ranged from approximately $25,000 to close to $9 million.

Top top

B. Income Statement and Balance Sheet Adjustments
Based on the survey information provided to us, PwC adjusted the income statement and the balance sheet of each company in accordance with the G4+1 proposal. The adjustments were based on the survey data and not on other data disclosed in financial statements.

Income Statement Adjustments. Pre-tax income was adjusted by: (i) reversing the deduction for rental payments attributable to capitalized operating leases, (ii) adding a deduction for amortization of capitalized operating leases, and (iii) adding a deduction for interest attributable to capitalized lease obligations. These adjustments can either increase or decrease pre-tax income. No adjustment was made for income taxes as these depend on company-specific factors.

Balance Sheet Adjustments. Assets and liabilities on the balance sheet were adjusted by including the capitalized value of operating lease obligations under the rules for capital leases in FAS 13. This affects a company's net property and equipment on the asset-side and its entries for current maturities of long-term debt and long-term debt on the liability-side of the balance sheet. No adjustment was made for deferred income taxes on the company's balance sheet.

Top top

C. Example of Lease Calculations and Adjustments
The following two tables (Tables 1 and 2) show how the PwC model uses the lease information reported on the survey to make income statement and balance sheet adjustments. For this example, we assume a lease commenced on March 1, 1997 with payments due the first of each month for 120 months. Monthly lease payments are $100,000 and the annual interest rate is 9.21 percent. We assume that this is an operating lease, but would be treated as a capital lease under the G4+1 proposal. Table 1 shows the calculations we make using the lease information obtained from the survey. Table 2 then shows how the calculations are used to make income statement and balance sheet adjustments.

Table 1

Lease Example: Calculations

Step

Description

Amount

1

Calculate the present value of the lease obligation as of 3/1/97. This is calculated as 120 monthly payments of $100,000 at an interest rate of 9.21% with payments due at the beginning of the period.

$7,883,851

2

Calculate the present value of the lease obligation as of 12/31/97. This is calculated as 110 monthly payments of $100,000 at an interest rate of 9.21% with payments due at the beginning of the period.

$7,467,068

3

Calculate the present value of the lease obligation as of 12/31/98. This is calculated as 98 monthly payments of $100,000 at an interest rate of 9.21% with payments due at the beginning of the period.

$6,922,989

4

Calculate the present value of the lease obligation as of 12/31/99. This is calculated as 86 monthly payments of $100,000 at an interest rate of 9.21% with payments due at the beginning of the period.

$6,326,629

5

Calculate payments of interest and principal made in 1998. This is calculated as 12 monthly payments of $100,000.

$1,200,000

6

Calculate payments of principal in 1998. This equals the amount calculated in step 2 minus the amount calculated in step 3.

$544,080

7

Calculate payments of interest in 1998. This equals the amount calculated in step 5 minus the amount calculated in step 6.

$655,920

8

Calculate the amortized value of the asset as of 12/31/97. This equals the amount calculated in step 1 minus 10 months of amortization.

$7,226,863

9

Calculate the amortized value of the asset as of 12/31/98. This equals the amount calculated in step 8 minus 12 months of amortization.

$6,438,478

10

Calculate amortization in 1998. This equals the amount calculated in step 8 minus the amount calculated in step 9.

$788,385

 

Table 2

Lease Example: Income Statement and Balance Sheet Adjustments

(negative amounts in parenthesis)

Adjustments to Income Statement, year ending 12/31/98

Item

Amount

Description

Rental expense

$1,200,000

Operating lease rental expense is reversed from original income statement. All rental expenses are assumed to be treated as current expenses.

Amortization

($788,385)

This equals the amount of amortization calculated in Table 1, step 10. This assumes all depreciation expenses are treated as current expenses.

Interest expense

($655,920)

This equals the interest on the present value of the lease obligation, which is calculated in Table 1, step 7.

Net change in income (before taxes)

($244,306)

This equals the sum of the changes in rental expense, amortization and interest expense.

Adjustments to Balance Sheet, year ending 12/31/98

Item

Amount

Description

Assets:

Property and equipment, net

$6,438,478

This equals the amortized value of the asset as of 12/31/98 (see Table 1, step 9).

Total Change in Assets

$6,438,478

This equals the change in property and equipment, net.

Liabilities:

Current maturities of long-term debt

$596,360

This equals the difference between the present value of the lease obligation as of 12/31/99 (Table 1, step 4) and the present value of the lease obligation as of 12/31/98 (Table 1, step 3).

Long-term debt

$6,326,629

This equals the present value of the lease obligation as of 12/31/99 (Table 1, step 4).

Total Change in Liabilities

$6,922,989

This equals the sum of the change in the current maturities of long-term debt and the change in long-term debt.

Net Worth:

Total Change in Net Worth

($484,511)

This equals the change in assets minus the change in liabilities.

Top top

IV. Results
Table 3 shows the income statement adjustments that would arise had the four participating companies accounted for their operating leases as proposed in the G4+1 Special Report. Reported rental expenses would have been greater than under current accounting standards, while reported amortization and interest expense would have been lower. The overall impact on income would have been to lower reported income. These results aggregate the results of calculations made on a lease-by-lease basis. An examination of the individual lease results shows that the adjustments for rental expenses, amortization, and interest expense all move in the same direction as the aggregate results (shown in Table 3, below). For some individual leases, the net change in income is positive, although the aggregate result for each company is negative.

Table 3

Income Statement Adjustments

(in thousands of dollars; negative amounts in parentheses)

Company

Rental

Expense

Amortization

Interest Expense

Net Change

in Income

Company 1

$5,592

($3,659)

($2,989)

($1,056)

Company 2

$4,975

($3,888)

($1,684)

($597)

Company 3

$7,869

($6,448)

($1,859)

($439)

Company 4

$148,462

($82,959)

($92,207)

($26,704)

Table 4 shows the balance sheet adjustments that would arise under the G4+1 proposal. Total reported assets would increase as would total reported liabilities.

Table 4

Balance Sheet Adjustments

(in thousands of dollars; negative amounts in parentheses)

Assets

Company

Property and Equipment, Net

Total Change

in Assets

Company 1

$43,452

$43,452

Company 2

$19,907

$19,907

Company 3

$63,508

$63,508

Company 4

$1,029,397

$1,029,397

Liabilities

Company

Current Maturities of Long-term Debt

Long-term

Debt

Total Change

in Liabilities

Company 1

$3,468

$41,897

$45,364

Company 2

$4,590

$16,249

$20,838

Company 3

$11,672

$52,274

$63,947

Company 4

$59,529

$1,157,104

$1,216,633

Net Worth

Company

Total Change

in Net Worth

Company 1

($1,912)

Company 2

($931)

Company 3

($439)

Company 4

($187,236)

Table 5 shows the income statement adjustments reported in Table 3 as a percent of each company's net income for the year ending December 31, 1998. In the case of Company 1, which reported a loss for 1998, the standards proposed in the G4+1 Special Report would have increased its loss by approximately 23 percent. Company 2, which also reported a loss for the year, would likewise have had a 3 percent greater loss than the company actually reported. Net income reported by Company 3 and Company 4 would have been lower by approximately 3.5 percent and 2.3 percent, respectively.

Table 5

Impact of the G4+1 Proposal on Net Income

(in thousands of dollars, except where noted;

negative amounts in parentheses)

Company

Net Change

in Income

Net Income (Loss) for Year Ended 12/31/98

Impact on Net Income

(% change)

Company 1

($1,056)

($4,678)

(22.6%) *

Company 2

($597)

($19,857)

(3.0%) *

Company 3

($439)

$12,654

(3.5%)

Company 4

($26,704)

$1,155,000

(2.3%)

* Percent increase in reported loss.

Table 6 shows the balance sheet adjustments reported in Table 4 as a percent of each company's assets, liabilities, and net worth as of December 31, 1998. Had the G4+1 proposal's standard for lease accounting been followed, all four companies would have reported a greater amount of assets. The increases ranged from 4.5 percent to 18.5 percent. The reported level of liabilities under the G4+1 proposal would have also increased relative to the liabilities actually reported. These increases ranged from just over 8 percent to approximately 16 percent. In all four cases, net worth reported on the balance sheet would have shown a decline. The magnitude of the declines relative to each company's reported net worth ranged from 0.2 percent to 4.3 percent. In summary, had the four companies included in the analysis accounted for operating leases as proposed in the G4+1 Special Report, there would have an adverse impact on their financial statements. In all four cases, both net income and net worth would be lower than that reported under current financial accounting standards. For the sample of firms that participated in this study, the financial statement impact of the G4+1 proposal was largest, in percentage terms, for the company with the weakest balance sheet.

Table 6

Impact of the G4+1 Proposal on Assets, Liabilities and Net Worth

(in thousands of dollars, except where noted;

negative amounts in parentheses)

Assets

Company

Total Change

in Assets

Assets as of 12/31/98

Impact on Assets

(% change)

Company 1

$43,452

$235,087

18.5%

Company 2

$19,907

$285,914

7.0%

Company 3

$63,508

$1,075,812

5.9%

Company 4

$1,029,397

$22,690,000

4.5%

Liabilities

Company

Total Change

in Liabilities

Liabilities as of 12/31/98

Impact on Liabilities

(% change)

Company 1

$45,364

$279,227

16.2%

Company 2

$20,838

$168,644

12.4%

Company 3

$63,947

$793,582

8.1%

Company 4

$1,216,633

$14,920,000

8.2%

Net Worth

Company

Total Change

in Net Worth

Net Worth (Deficit) as of 12/31/98

Impact on

Net Worth

(% change)

Company 1

($1,912)

($44,140)

(4.3%) *

Company 2

($931)

$117,270

(0.8%)

Company 3

($439)

$282,230

(0.2%)

Company 4

($187,236)

$7,770,000

(2.4%)

* Percent increase in net worth deficit.

Top top

Footnotes

1 The proposal analyzed in this study is one described in a July 1996 G4+1 Special Report entitled Accounting for Leases: A New Approach-Recognition by Lessees of Assets and Liabilities Arising Under Lease Contracts. Warren McGregor was the principal author of the report.

2 FAS 13, ¦ 7.

3 FAS 13, ¦ 10.

4 FAS 13, ¦ 15.

5 Interviews conducted by the Barents Group with representatives of a range of organizations, including the FASB, the Securities and Exchange Commission (SEC), the Association for Investment Management and Research (AIMR), and Standard & Poor's (S&P) rating service, show that there is substantial agreement that FAS 13 is too complex and allows too many leases to be kept off lessees' balance sheets. See Preliminary Investigation of Potential Impacts of Changing to an Asset/Liability Framework in Accounting for Leases, October 5, 1998.

6 This has been observed by Imhoff and Thomas in "Economic Consequences of Accounting Standards: The Lease Disclosure Rate Change" (Journal of Accounting and Economics, December 1988); Gallery in "An Analysis of Lease Reporting Practices by Lessee Firms in a Regulated Environment" (Honours Thesis, University of Queensland, 1993; and Gallery and Zimmer in "Leasing and Accounting Standards" (unpublished paper, University of Queensland, September 1994).

7 See Imhoff, Lipe, and Wright, "Operating Leases: Impact of Constructive Capitalisation", Accounting Horizons, March 1991.

8 In December 1999, the Accounting Standards Board issued a Discussion Paper (Leases: Implementation of a New Approach) that presented a Position Paper developed by the G4+1 Group of accounting standard-setters. This second G4+1 paper goes beyond the G4+1's 1996 Special Report, which provided a conceptual foundation for revised lease accounting standards. The Position Paper represents further thinking by the G4+1 Group. This second paper discusses the principles the G4+1 Group believes should determine the extent of the assets and liabilities that lessees and lessors would recognize under leases. In addition, the Position Paper considers how these principles might be applied to account for features found in lease contracts.

9 For reference, FAS 13 applied to all new leases entered into after January 1, 1977, and was applied retroactively to all leases for financial statements issued after December 31, 1980.

10 Appendix A provides a copy of the letter sent to survey participants that described the study and how the information submitted would be used. A copy of the survey questionnaire and an accompanying information document, which describes the PwC survey methodology and data needs, are provided in Appendix B of this report.

Top top