Operating Leases

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© 1997 American Accounting Association Accounting Horizons Vol. 11 No. 2 June 1997 pp.12-32

Operating Leases: Income Effects of Constructive Capitalization Eugene A. Imhoff, Jr.. Robert C. Lipe and David W. Wright
Eugene A. Imhoff, Jr. is Professor at University of Michigan, Robert C. Lipe is Associate Professor at University of Colorado at Boulder and David W. Wright is Associate Professor at University of Michigan. SYNOPSIS: Lease contracts written in 1994 in the U.S. have been estimated at over $140 billion (London Financial Group Ltd. 1996). The amount of leasing activity continues to grow, particularly op erating-type leases which provide a source of off-baiance sheet financing. However, a recent publication by an international group of representatives from the FASB and six other national and international accounting standard setting bodies suggests that iease accounting should require alt lease contracts to be capitalized as assets and liabilities (McGregor 1996). This suggestion has also been made by the Association for Investment Management and Research (AMIR) in a December 1993 white paper. A previous Horizons paper by Imhoff et al. (1991) illustrated how to constructively capitalize operating leases. However, this prior study focused exclusively on the balance sheet effects for a single period, and assumed the income statement effects were negligible. The current study cites evidence that suggests the income statement effects may be material, and illustrates how to estimate the impact of constructive capitalization of operating leases on both operating income (before interest expense) and net income. Understanding both the income statement and balance sheet consequences will likely become increasingly important as the sentiment that operating leases should be capitalized continues to gain favor with users and standard setters. Key Words: Operating leases. Off-balance sheet financing.

INTRODUCTION
An earlier paper in this journal reported on methods of estimating the off-halance sheet assets and liabilities represented hy a firm's long-term operating leases (Imhoff et al. 1991) (hereafter ILW). This process, referred to as the constructive capitalization of operating leases, focused on the single-period balance sheet effects of restating operating leases as capital leases. The paper's focus was to illustrate the impact of adjusting the assets and liabilities on two key financial ratios: return on assets (ROA) and debt to equity (D/E). However, in doing so, the adjustments to both net income and operating income that would have resulted from the constructive capitalization of operating leases were assumed to be zero. The accuracy of this simplifying assumption is challenged by subsequent research demon-

strating a potentially significant effect on both net income ("bottom line income") and operating income (income before interest expense and unusual items)fi-omthe constructive capitalization of operating leases. For example, ILW (1993) found a median decrease to net income of 22 percent among sample firms in the airline industry, and a median increase in operating income of 34 percent.^ ^ The variation in adjustments to both net income and operating income is substantial. The first and third quartile observations in the airline and retail grocery industries were (ILW 1993): First Quartile Third Quartile Net Operating Net Operating Income Income Income Income Airlines -52% +8% -3% +73% Groceries -17% +6% +1% +36% Submitted June 1996 Accepted February 1997 Corresponding author: Eugene Imhoff Email: itnhaf^>uniich.edu

Operating Leases: Income Effects of Constructive Capitalization

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This paper illustrates how to estimate the effect of constructively capitalizing operating leases on both net income and operating income, and how to identify the settings in which these income statement effects will be material. These adjustments have the potential to significantly alter a number of important measures...
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