Question

Sherry talbot, the CEO of Talbot Coporation, was meeting with the company controller to discuss a possible major lease of a new production facility. Talbot Corp. had a large amount of debt, and Sherry was concerned that adding more debt to acquire the production facility would worry stockholders. Sherry knew that if the production facility could be classified as an operating lease rather than a capital lease, the obligation would not have to be reported on the balance sheet. Thus, the company could have a new production facility without having to report any additional debt. The accountant told Sherry that if the title to the production facility transferred automatically to Talbot at the end of the lease term, then the lease would have to be classified as a capital lease. Also, if the lease had a bargain purchase option, such that the Talbot corp. could simply purchase the facility at the end of the lease term for a small amount, it would also be classified as a capital lease. Sherry said not to worry because she would make sure that the lease contract would not contain any title transfer or bargain purchase option. The accountant then said that the facility had a 25-year life and the lease was for 20 years, which was more than 75 percent of the economic life of the asset, so it would have to be classified as a capital lease. Sherry then said she would change the lease term to 18 years, so the lease term would be less than the 75 percent of the economic life of the facility. The accountant then computed the present value of the lease payments, and . the total was more than 90 percent of the market value of the facility. Again Sherry said she would make any needed changes so that the total present value of the payments would be 89 percent of the current market value of the facility. At this point the accountant became frustrated and told Sherry that the rules of accounting used to determine the proper classification of a lease were not meant to be used in order to misclassify a leased asset and thereby provide misleading information. Sherry then said that the rules simply served as a guide for structuring the lease and that she was merely using the rules to allow the lease to be classified as an operating lease and thus the lease obligation would not have to be recorded. The accountant said that intentionally avoiding the rules was unethical and wrong. 1. Why does Sherry want to have the lease classified as an operating lease rather than a capital lease? 2. Does the accountant have a legitimate argument? Does Sherry have a legitimate argument? 3. What ethical issues are involved? 4. Do you have any other thoughts?

Answer 1

Answer 1:

Sherry wanted the entire transaction to be recorded as an operating lease as he does not want to show the liability as well as fixed asset on the balance sheet. If the lease is recorded as capital lease the entire obligation of lease payments would be shown as additional liability and the production facility would be recorded as a fixed asset. The additional liability would affect the ratios including debt to equity. This would give negative signals to the stock holders of the repayment capacity. To avoid the negative vibrations Sherry does not want to show the same as capital lease and record the yearly lease payments as expense. By recording as a operating lease her intention of using the new production facility would be achieved and no liability would be there on the balance sheet.

Answer 2:

The accountant has a very a argument. If any asset is taken on lease with a intention to acquire the asset in the long run the lease should be classified as a capital lease. In the said all the conditions of capital lease have been complied with. However just to ensure that accounting guidelines are met theoretically the conditions have been tweaked which is quite unethical. The conditions with respect to present value of MLP, useful life of asset, and bargain purchase option are met to classify as capital lease, however Sherry would like to tweak the lease agreement and conditions which is not ethical as the basic intention is defeated.

Answer 3:

The situation involved has ethical issues to deal with. Even though Sherry did not in principle deviate the accounting guidelines the whole intention of the guideline has been not met. This would not give true picture of the financial statements to the stakeholders and this would be misrepresentation of facts and data. The accountant should consider reporting the same to the higher management and if no action is taken he should consider disassociating with such project or work.

Answer 4:

Sherry tweaking the conditions of the lease agreement in line with accounting guidelines is not completely wrong on paper. However when we want to understand the fair picture of the financial statements we could not get that. Ethically what Sherry has done is wrong as the rules are being avoided intentionally, however on paper she complied with the accounting guidelines.