Forensics Journal - Stevenson University 2015 | Page 10

STEVENSON UNIVERSITY

Accordingly, a corporation may disguise a capital lease as an operating
lease by arguing the following criteria stipulated by FASB Statement
No. 13:

the implicit rate of return. Utilizing a higher rate to discount the
minimum lease payments to present value will consequently lower
the probability of payments totaling or exceeding 90% of the asset’s
fair value (Ketz, 2003, p. 90). This provides the lessee flexibility
in utilizing either the implicit rate of return or the borrower’s
incremental borrowing rate to discount the minimum lease payments.
Although the FASB requires the lessee to use the lower rate of the two
if known, the lessee may actually employ creative accounting practices
by selecting the higher rate to discount the minimum lease payments
to reflect less than 90% of the asset’s fair value (Ketz, 2003, p. 90).

1. Passage of title to the lessee
2. Bargain purchase option
3. 
Lease term equals or is greater than 75% of the useful
life of the asset
4. 
Present value of the minimum lease payments equals or
is greater than 90% of the fair value of the property
If any one of these criteria is met, then the lease is treated as a capital
lease. However, if all four criteria fail, then the lease is treated as an
operating lease (Ketz, 2003, p. 89).

Another technique to avoid capitalizing a lease is not guaranteeing
the residual value. Unguaranteed residual values do not require a
payment from the lessee at the end of the lease term; therefore, the
FASB specifies that unguaranteed residuals cannot be included in the
minimum lease payments (Ketz, 2003, p. 91). Unguaranteed residual
values can lower the total value of the minimum lease payments to
equal less than 90%. A lessee may require unguaranteed residual
values when structuring a lease agreement so as to lower the total
value of the minimum lease and to report it as an operating lease.
The connection between the two rate types (implicit rate of return
and borrower’s incremental borrowing rate) and the unguaranteed
residual value is that the lessee may abuse the flexibility provided
in the FASB accounting regulations for off-balance-sheet financing.
The flexibility of these particular regulations are problematic for
creditors and investors as they do not provide the corporation’s
accurate financial profile.

First, the passage of a title from the lessor to the lessee usually does
not occur until the end when all lease obligations are complete;
therefore, allowing a corporation to claim this criterion has not been
met. Second, the option to purchase at a bargain price may not be
established until the end of the lease, wherein this criterion may
not suffice until that point. Third, the length of the lease’s term is a
significant factor in determining whether the lease is categorized as
an operating lease or a capital lease. If the lease represents 75% or
more of the useful life of the asset, then it appears that the lessee has
completed a purchase transaction. Again, this criterion may not be
met until the length of the lease has reached 75% of the useful life
of the asset. Last, the fourth criterion suggests that if the present value
of the minimum lease payments is comparable to the total fair value
of the asset, then the lessee has completed the purchase. Leases may
be devised to reflect the present value of minimum lease payments
just below the stated criterion for the purpose of disguising the lease
as an operating lease (Ketz, 2003, p. 89). Therefore, a corporation
may report a lease as an operating lease to avoid recording a capital
lease obligation. Gerald Lander and Kathleen Auger in “The Need
for Transparency in Financial Reporting” note that establishing
precise guidelines in terms of percentages allow corporations to
structure their lease agreements in order to achieve the greatest
benefit (Lander & Auger, 2008, p. 33). A lease agreement may
be structured to represent 74% of the asset’s useful life, yet the
present value of the minimum lease payments reflects 89%, thus
creating conditions favorable to an operating lease designation.

In comparison with unguaranteed residual values, contingent
rental payments are also excluded from minimum lease payments.
In exchange for a standard monthly lease payment, the lessee may
offer the lessor a lower monthly lease payment with a contingent
percentage of sales each month to lower the total value of the
minimum lease payments (Ketz, 2003, p. 91). Consequently, the
lessee will avoid reporting the lease as a capital lease; since the total
value of minimum lease payments only includes the lower monthly
lease payments discounted to present value i.e. the total value equals
less than 90%. All of these methods are in accordance with the FASB
regulations for lease accounting. However, the methods result in
customized lease agreements beneficial to only one party.
To detect hidden financial risks, an effective auditor must examine
the corporation’s lease agreements in accordance with FASB Statement
No. 13. The auditor must determine the following: identify type
and accounting of leases (operating or capital); verify present value
computations and determine appropriateness of the discount rate
used; ensure lease agreements specify whether the residual values
are guaranteed or unguaranteed; identify existence of contingent
rental payments; and vouch the lease payments and expenses to the
provisions of the lease agreements to obtain a better understanding
of these transactions. In addition, the auditor can pursue independent

In Hidden Financial Risk: Understanding Off-balance-sheet Accounting,
Edward Ketz argues that a lessee may claim ignorance to avoid
reporting a capital lease. A lessee appears ignorant of the implicit
rate of return used to calculate the present value of the minimum
lease payments. This approach is unlikely as the information can be
obtained from the lessor. However, if the implicit rate of return is
a true unknown, the FASB permits the lessee to use the borrower’s
incremental borrowing rate (a standard interest rate applied to
payments for financing a purchase), which is usually higher than

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