Operating Leases: Income Effects of Constructive Capitalization.

Abstract 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 operating-type leases which provide a source of off-balance 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 lease 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.