BY: STEPHEN LARSON. Introduction

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Introduction

This is a two part paper on Statement of Financial Accounting Standard (SFAS) No. 13-Capitalization of Leases (discussed in Part 1) and SFAS 96 and 109-Accounting for Income Taxes (discussed in Part 2). The purpose of this paper is, in Part 1, to analyze the capitalization of leases and in Part 2, analyze and differentiate SFAS 96 and FAS 109 and how they relate to APB 11.

Part 1

SFAS Number 13: Leases General Overview and History

In November of 1976, the APB, predecessor to the FASB, issued ABP Opinion 13: Accounting for Leases (FASB, 2008). The opinion superseded APB Opinions 5 and 7 completely and portions of APB Opinions 18, 27, and 31. It provided a common definition of terms related to leasing activities, established the concept of effective ownership whether rights of ownership passed, and the need to record the related assets and liabilities on the financial statements (FASB, 2008). In its efforts to determine whether an asset and related liability should be recorded, APB 13 created two types of leases- operating and capital. Operating leases would be accounted for as annual rental agreements without any disclosed liabilities other than note disclosures of the

commitment. Capital leases would require the capitalization of the leased asset and the recognition of the related liability of the future lease payments on the balance sheet.

Over the next 30 years, minimal changes to the accounting for leases occurred. Now known as SFAS 13, accounting for leases remained consistent with the

methodology created in November, 1976. However, during this same time period, the leasing industry grew to over $1 trillion and had become a common choice in the financing of equipment acquisition and use (Wendel & Williams, 2001). Most

commercial equipment is a candidate for leasing including airplanes, trains, vehicles, fire trucks, garbage trucks, computers, video equipment, etc. Even the SEC recognized the prevalence of leasing and reported to Congress in June, 2005, that there was a significant use of leasing by U.S. businesses (Hamilton, 2012).

With the growth in leasing as a financing tool, a review of the accounting methodology was inevitable. Because of the significant use of leasing in business, the current lease accounting approach had to be reviewed to determine if it was sufficient to properly state the financial condition of the business entity given today’s business practice.

Current Approach

SFAS 13 (currently FASB Codification Topic 840) creates two types of leases-operating leases and capital leases. For leases-operating leases, the business entity is to treat the lease as a rental relationship and record the lease payment as a period expense when the interim lease period is completed (FASB, 2008). For capital leases, the present value of the future lease payments is to be determined and reflected as a liability on the balance

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sheet and a related asset for the item being leased is to be shown on the balance sheet as an asset (FASB, 2008).

An issue is the determination of a capital lease. SFAS 13 (FASB, 2008) provides 4 criteria, any of which triggers capitalization:

 Does title transfer at the end of the lease?  Is there a bargain purchase price?

 Is the lease term for 75% or more of the economic life of the asset being leased?  Is the present value of the lease payments 90% or more of the fair market value of the

asset at the date of the lease?

If any one of these factors occurs, the transaction is considered to be a capital lease for both the lessee and the lessor and the corresponding lease obligation or

receivable and related asset are to be recorded on the balance sheet. For the lessee, as the periodic lease payment is made, the lease obligation is reduced and interest expense is recorded as well as the depreciation expense on the capitalized asset. For the lessor, the lease receivable is capitalized and as payment is received, the interest on the receivable is recognized as income.

An example will serve to illustrate a capitalized lease transaction more clearly. Assume the following information relating to a lease agreement:

 Equipment with a 10 year life is leased for 5 years beginning January 1, 2011  Annual lease payment is $60,000 due at the beginning of the year

 Fair market value of the equipment at date of lease is $250,192  Interest rate is 10%

 Title does not pass nor is there a bargain purchase price  There is no residual value

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Determination of type of lease.

Test of 4 triggers:

1 Title passes NO

2 Bargain purchase price NO 3 75 % of the economic life NO

Lease term is 5 years

Economic life of asset is 10 years

4 95% of the FMV YES

PV of annual payments $ 250,192 FMV of equipment $ 250,192 PV as a % of FMV 100%

Test 4 is YES, therefore this is a capitalized lease.

Lessee

PV of future lease payments $250,192

Lease amortization schedule 10%

Interest Obligation Obligation Year Description Expense Payment Reduction Balance

2011 Initial Balance $ 250,192

2011 Payment 1 $ 60,000 $ 60,000 190,192 2012 Payment 2 $ 19,019 60,000 40,981 149,211 2013 Payment 3 14,921 60,000 45,079 104,132 2014 Payment 4 10,413 60,000 49,587 54,545 2015 Payment 5 5,455 60,000 54,545 0

Entries

2011 DR Capitalized Equipment $ 250,192

CR Capitalized Lease Obligation $ 250,192

2011-1 DR Capitalized Lease Obligation $ 60,000

CR Cash $ 60,000

2011-2 DR Depreciation Expense $ 50,038

CR Accumulated Depreciation $ 50,038

2012-1 DR Interest Expense $ 19,019 DR Capitalized Lease Obligation $ 40,981

CR Cash $ 60,000

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CR Cash $ 60,000

Lessor

PV of future lease payments $250,192

Lease amortization schedule

10%

Interest Receivable Receivable Year Description Revenue Payment Reduction Balance

2011 Initial Balance $ 250,192

2011 Payment 1 $ 60,000 $ 60,000 190,192 2012 Payment 2 $ 19,019 60,000 40,981 149,211 2013 Payment 3 14,921 60,000 45,079 104,132 2014 Payment 4 10,413 60,000 49,587 54,545 2015 Payment 5 5,455 60,000 54,545 0 Entries

2011 DR Lease Payments Receivable $ 250,192

CR Equipment Purchased for Lease $ 250,192

2011-1 DR Cash $ 60,000

CR Lease Payments Receivable $ 60,000

2012-1 DR Cash $ 60,000

CR Lease Payments Receivable $ 40,981 CR Interest Revenue $ 19,019

2013-1 DR Cash $ 60,000

2014-1 DR Cash $ 60,000

2015-1 DR Cash $ 60,000

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Arguments in favor of capitalizing leases that do not meet SFAS 13 triggers

Capitalization of operating leases arises from the perspective that operating leases represent property rights. The primary issue is that obligations arising out of long-term operating leases are not properly reflected on the balance sheet as liabilities (FASB, 2010 Exposure draft). This situation gives rise to a condition of off-balance sheet accounting for long-term liabilities. An operating lease provides a right to use an asset for an extended period of time. This right of use creates an asset and a related liability that should be reflected on the balance sheet of the lessee. An operating lease does create an event that should be reflected on the balance sheet in order to more accurately reflect the economic substance of the transaction (Thanner, 2012) and to provide a basis of

comparability among business entities involved in leasing activities (FASB, 2010 Exposure draft). To omit information regarding the rights and obligations that represent assets and liabilities would not provide a proper representation of the leasing transaction (FASB, 2010 Exposure Draft). Additionally, there are currently two methods of lease accounting. If all leases were capitalized then only one method would exist.

Arguments against capitalizing leases that do not meet SFAS 13 triggers Leases that are not capitalized are called operating leases. These types of relationships involve no transfer of ownership and are generally rental arrangements. Characteristics of operating leases include non-ownership of the property used, no recognition on the financial statements of the long-term commitment (assets or

liabilities), disclosure in the notes to the financial statements in line with contingencies noting the future cash flow impact, lease payments recognized as expense on the part of the lessee when incurred and revenue by the lessor when earned, and planned return of the item leased. The use of operating leases can minimize the impact on the balance sheet by not recording the liability or the asset (Duke & Hsieh, 2006) which is merely a business decision, not an accounting decision. The decision of a company to purchase an asset or rent an asset is based on multiple factors. SFAS 13 already takes into

consideration usage and value components to determine if the lease transaction resembles a purchase. Why change the rules that have existed for 30 years. In the Duke & Hsieh study it was determined that by switching to a capitalized lease concept, operating income decreases and debt to equity ratios decline resulting in a negative impact on the financial performance of a company (Duke & Hsieh, 2006). In (Schroeder, Myrtle &Cathey, 2011), capitalizing all leases will negatively impact the leasing industry because the action will reduce management’s options to improve operating ratios, increase availability of capital, and improve debt ratings.

FASB/IASB Joint Project on Leases

Actually, the above discussion is somewhat passé as the position of the

FASB/IASB is that since leasing is a significant activity of business, it is important that the accounting for leases provides the users of the financial statement with the

appropriate financial information reflecting the economic substance of the transaction (FASB, 2013 Project update). Accordingly, the FASB/IASB has proposed several

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changes to the existing lease accounting rules for equipment and real estate. These changes include the following:

 Lessee would recognize as an asset its right to use that asset and the liability to make the required lease payments (FASB, 2010 Exposure Draft).

 Lessor would recognize an asset representing the future lease payments to be received and the related liability to provide the asset to the lessee (FASB, 2010 Exposure Draft).  For any leases with a life of 12 months or less, the payments would be treated as a

period expense for the lessee and period revenue for the lessor (FASB, 2010 Exposure Draft).

After investigation, from a pure accounting perspective, the capitalization of operating leases is of minimal difference to that of capital leases today. What does change is the definition of what is capitalized and the potential impact on the financial statements for recognizing the assets and obligations resulting from operating leases that will now be capitalized. The current approach does not reflect any balance sheet event for operating leases. In this regard, the FASB/IASB accomplished its primary goal to place the effect of the long-term financing of an operating lease on the balance sheet. Conclusion

Opposition to the proposed changes has been robust, especially from the leasing industry as well as from the U.S. Chamber of Commerce (Jones, 2013). Changes to accounting rules are often met with resistance. In a recent speech, IASB Chairman Hoorgervorst identified the challenge and noted that changing the current approach of lease accounting would be difficult (Jones, 2013). This resistance comes from the fact that the proposed changes will increase the financial liabilities reported on the balance sheet of business entities (Purcell, 2012). The proposed approach basically eliminates operating leases, as reported today, with the exception of short-term lease agreements. For those who continue to argue, time is running out. The FASB and the IASB have agreed on the approach to lease accounting (Byatt & Pappas 2012). That approach requires the recognition of the liability and asset on the balance sheet for all leases except those involving 12 months or less. Though additional discussions continue to modify the approach (Chasan, 2013), what is now clear is the need to begin preparing for the change by identifying the financial impact, communicating the financial effects of the change to stakeholders, and educating the accounting departments on the new approaches to lease accounting.

As a side note, a study of 3,000 companies worldwide by

PriceWaterhouse/Coopers and Rotterdam University in the Netherlands concluded that reported debt would increase by 58% as a result of the proposed approach (Apostolou, 2011). Maybe the FASB and the IASB are correct when they note that liabilities are understated using the current approach to lease accounting.

Part 2

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Overview

Income taxes are an accepted cost of doing business in the U.S. Consequently, when income taxes are incurred, they become an expense of the business entity for the period. However, accounting for income taxes was a major issue in regards to reporting and measurement criteria prior to SFAS 109 (Schroeder, Myrtle & Cathey, 2011). Prior to 1940, income taxes were expensed on the books as incurred (Schroeder, Myrtle & Cathey, 2011). However, in 1940, the Internal Revenue Code (IRC) allowed business to accelerate depreciation on certain types of assets. For book purposes, businesses

continued to use the previously establish depreciation approaches, but for tax purposes, they took advantage of the acceleration of recognition of expenses and benefited from a reduction in tax liability over the reduced time period. However, by the end of the time period used in the books, total depreciation expense was the same. This created a timing difference between recognition of depreciation expense on the books and depreciation expense recognized on the tax return. Over the long run, the net effect was zero. Accounting Research Bulletin (ARB) Number 23 took the position that income taxes should be allocated to income on the accrual basis ignoring the timing of payments (Schroeder, Myrtle & Cathey, 2011). Consequently, income tax expense should be allocated to the period incurred. However, ARB 23 did not address continuous book/tax differences over a long period of time nor did it provide guidance on measurement of tax impacts resulting in the issuance of Accounting Principles Board (APB) Opinion 11.

APB 11 continued the concept of inter-period tax allocation developed by ARB 23 but added the concept of deferred taxes which included the measurement of future taxes and their impact. The effort was focused on matching revenues with the expenses related to the generation of, and resulting from, those revenues. But APB 11, in its measurement guidance, used current tax rates and many felt that future tax rates should be used. SFAS 96 was issued requiring the use of future tax rates. SFAS 96 was later superseded by SFAS 109 which is currently the accounting standard for income tax accounting and is now incorporated in Accounting Standards Codification Topic 740. Comparison of SFAS 96 with APB 11

APB 11 was issued in 1967 and established the deferred method of accounting for income taxes on timing differences. The tax effects of the timing differences were shown on the balance sheet as deferred credits and deferred charges. APB 11 resulted from interpretations and amendments and was criticized for inconsistency, ambiguity, and an inability to create comfort at the financial statement preparer level (Dudzinsky, 1993). In response to criticisms about the methodology and reporting of the deferred credits and charges, the Financial Accounting Standards Board (FASB) issued SFAS 96 in 1987 replacing APB 11 and requiring an asset-liability method of accounting for income taxes rather than the deferred method (Cassidy, Urbancic, Sylvestre, & Ralston, 2011). SFAS 96’s asset-liability method was criticized as being more complicated than APB 11 and resulted in the FASB postponing issuance three times. Businesses were originally required to adopt SFAS 96 for years beginning after December 15, 1988 but with the postponements were not required to implement until years beginning after December 15, 1992 (Cassidy, Urbancic, Sylvestre, & Ralston, 2011). Under SFAS 96, the deferred

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amounts for taxes were computed using the tax rates in effect for the years involved requiring the keeping of records for each tax year for each tax jurisdiction. Any

adjustments were run through income tax expense. This was different from APB 11 as APB 11 required only the current tax rate be used for future tax events. Any subsequent changes in tax rates were not to be considered.

By requiring an asset-liability approach, the FASB moved away from the matching concept and focus on the income statement to focus on the balance sheet and net realizable value (Wolk, Martin, & Nichols, 1989). The new approach was very formula intensive requiring the use of significant assumptions for the calculation of future taxes on timing differences and the determination of an asset or liability. Present value concepts were ignored as was the impact of permanent deferrals (Wolk et al., 1989). Wolk’s study suggested that APB 11 was at least grounded in the concept of matching whereas SFAS 96 moved to an asset-liability measurement and recognition issue that left income tax allocation in an unsatisfactory state.

APB 11 classified deferred taxes as either current or noncurrent based on the related asset or liability but SFAS 96 determined the classification based on the expected reversal date of the temporary difference (Byington, 1992).

Comparison of SFAS 109 with SFAS 96

SFAS 109 was issued in 1992 superseding SFAS 96. SFAS 96 was considered more complicated than APB 11 and was quite controversial (Dudzinsky, 1993). Consequently, the FASB issued SFAS 109 to provide additional reform to income tax accounting. The objective of SFAS 109 was to determine the standards for accounting and reporting for income taxes that are currently payable. SFAS 109 was a complete re-evaluation of the income tax area with emphasis on asset-liability methodologies

addressing the tax consequences of revenues, expenses, gains and losses for other years (past and future) than the year which they are recognized in the financial statements. The recognition of net operating losses (NOL’s) and tax credits were an integral part of the impact on past and future years’ tax assets and liabilities. SFAS 96 did no recognized loss carryforwards as assets, however, SFAS 109 recognized them along with a valuation account based on more likely than not philosophies (Byington, 1992). SFAS 109

continued the asset-liability approach of SFAS 96 but clarified the treatment of NOL’s and tax credits along with establishing the condition that future changes in currently enacted tax rates were not to be considered and that the determination of future impacts on tax events were, at best, estimates and approximations (Dudzinsky, 1993).

Additionally, SFAS switched from enacted tax rates, as stated in SFAS 96, to marginal tax rates (Byington, 1992). SFAS 109 returned back to the APB 11 treatment for current/noncurrent and made the classification based on the related asset or liability (Byington, 1992).

Comparison of SFAS 109 with APB 11

SFAS 109 required separate reporting of the components of deferred taxes while APB 11 allowed netting of the components. There were concerns that APB 11 was not consistent with the definitions of assets and liabilities as noted in Statement of Financial

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Accounting Concepts (SFAC) 6. SFAS 109 was more in line with the SFAC 6 definitions (Legoria & Sellers, 2005) as assets and liabilities were to be separately disclosed and the assets were to undergo impairment valuation measurements.

Additionally, it was noted by B. C. Ayers in a 1998 study that SFAS 109 provided more relevant information than APB 11 by separating the components of the deferred taxes and requiring adjustments for changes in future tax rates as they became known. This

allowed for better estimation of future cash flows (Legoria & Sellers, 2005). However, some critics argued that the cost benefit relationship was not supported in SFAS 109 (Legoria & Sellers, 2005) and a study done by Deloitte and Touche (currently known as Deloitte) in 1992 concluded that the cost of complying with SFAS 109 was more than the cost of complying with APB 11 (Legoria & Sellers, 2005).

Tax liabilities were to be developed by using enacted tax rates for the future years impacted (Dudzinsky, 1993). This was a significant difference from APB 11 as only current tax rates were used in calculating the tax liability. Under SFAS 109 the concept of a valuation allowance account for the deferred tax asset account was established because of the impairment approach required under SFAS 109. The standard went into significant detail about the determination of a valuation allowance account and any exceptions that may be allowed (Dudzinsky, 1993).

APB 11 treated the tax benefits of loss carryforwards as extraordinary items but SFAS 109 treated them the same as in SFAS 96-classified in the financial statements based on the items that created them (Byington, 1992).

Conclusion

Prior to SFAS 109, significant confusion and controversy existed for accounting for income tax related timing issues. SFAS 109 reduced the controversy and simplified the accounting for income taxes (Dudzinsky, 1993). SFAS 109 resulted from the FASB’s effort to reduce the computational issues experienced under SFAS 96. The standard permits subjectiveness in the measurements but realistic assumptions based on going concern philosophies (Byington, 1992). The result was an increase in the use of judgment moving the accounting profession to a more principles-based approach to implementation of accounting standards.

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Byatt, M. & Pappas, J. (2012). IASB and FASB agree on lease accounting approach. News release FASB and IASB. June 13, 2012.

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