Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Leasing © The McGraw−Hill^901
Companies, 2002
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:- The lease transfers ownership of the property to the lessee by the end of the term of
the lease. - The lessee can purchase the asset at a price below fair market value (bargain
purchase price option) when the lease expires. - The lease term is 75 percent or more of the estimated economic life of the asset.
- 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 arrange-
ment 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 advan-
tages 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, tradi-
tional 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 manipula-
tion would mislead many people.TAXES, THE IRS, AND LEASES
The lessee can deduct lease payments for income tax purposes if the lease is deemed to
be a true lease by the Internal Revenue Service. The tax shields associated with lease
payments are critical to the economic viability of a lease, so IRS guidelines are an im-
portant consideration. Essentially, the IRS requires that a lease be primarily for business
purposes and not merely for purposes of tax avoidance.
In broad terms, a lease that is valid from the IRS’s perspective will meet the follow-
ing standards:CONCEPT QUESTIONS
26.2a For accounting purposes, what constitutes a capital lease?
26.2bHow are capital leases reported?878 PART EIGHT Topics in Corporate Finance