Operating Leases or Capital Leases
Suppose you were the chief financial officer (CFO) of Southwest Airlines. Southwest leases some of its planes. Suppose the leases can be structured either as operating leases or as capital leases. Which type of lease would you prefer for Southwest? Why? Consider what would happen to Southwest s debt ratio if its operating leases in footnote 8 were capitalized, and the related liabilities recognized.
Computing Southwests debt ratio two ways (operating leases versus reclassifying them as capital leases) will make your decision clear (using Southwest s actual figures in millions): You can see that a capital lease increases the debt ratio by about five percentage points for Southwest, but a lot more for UAL and AMR (parent company of American Airlines). By contrast, notice that operating leases don t affect the debt ratio that's reported on the balance sheet. For this reason, companies prefer operating leases. It is easy to see why Southwests long-term commitment for operating leases, as disclosed in Note 8, far outweighs that of its capital lease agreements.
Ethical Challenge Because of the relatively mechanical nature of the accounting criteria for capitalization of leases, it is possible under existing U.S. GAAP to purposely structure a company's lease agreements so that they barely miss meeting the third criterion (75% test) or the fourth criterion (90% test) for capitalization. Many U.S. companies have taken advantage of these mechanical rules, quite legally, to their economic advantage, thus obtaining almost all the same economic benefits associated with ownership of long-term assets, but avoiding the detrimental impact that recording those assets and obligations can have on their debt ratios.
Pensions and Postretirement Liabilities
Most companies have retirement plans for their employees. A pension is employee compensation that will be received during retirement. Companies also provide postretirement benefits, such as medical insurance for retired former
Computing Southwests debt ratio two ways (operating leases versus reclassifying them as capital leases) will make your decision clear (using Southwest s actual figures in millions): You can see that a capital lease increases the debt ratio by about five percentage points for Southwest, but a lot more for UAL and AMR (parent company of American Airlines). By contrast, notice that operating leases don t affect the debt ratio that's reported on the balance sheet. For this reason, companies prefer operating leases. It is easy to see why Southwests long-term commitment for operating leases, as disclosed in Note 8, far outweighs that of its capital lease agreements.
Ethical Challenge Because of the relatively mechanical nature of the accounting criteria for capitalization of leases, it is possible under existing U.S. GAAP to purposely structure a company's lease agreements so that they barely miss meeting the third criterion (75% test) or the fourth criterion (90% test) for capitalization. Many U.S. companies have taken advantage of these mechanical rules, quite legally, to their economic advantage, thus obtaining almost all the same economic benefits associated with ownership of long-term assets, but avoiding the detrimental impact that recording those assets and obligations can have on their debt ratios.
Pensions and Postretirement Liabilities
Most companies have retirement plans for their employees. A pension is employee compensation that will be received during retirement. Companies also provide postretirement benefits, such as medical insurance for retired former