Book and Tax Considerations in OffBalance Sheet Leases

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Book and Tax Considerationsin Off-Balance Sheet
Leases

• 2002 AICPA Professor/Practitioner
• Case Development Program
• Special thanks to Professor Silvia Madeo
• for helpful comments.

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Co-Authors

• Christine Bauman, Assistant Professor
• University of Wisconsin-Milwaukee
• Robert Halsey, Assistant Professor
• Babson College
• Paula Hasbach, Senior Tax Manager
• PricewaterhouseCoopers, LLP

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Motivation

• The synthetic lease industry was thriving until
  December 2001 when Enron collapsed, highlighting
  the hazards of off-balance sheet financing. As a
  result, what appeared to be acceptable business
  practices for over 20 years became taboo
  overnight.

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Purpose of Case

• Introduce undergraduate and graduate accounting
  students to
• Interplay of accounting and tax rules
• Factors influencing changes in accounting rules
  and disclosures
• Transparency and ethics in accounting and tax
• Accounting and tax research

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Synthetic Lease

• Lessee agrees to pay rentals equal to interest
  and principal and to partially guarantee the
  residual value of the leased asset at the end of
  the lease term.
• Transaction involves setting up an SPE which
  borrows money to construct or purchase an asset.
  Then the SPE leases the asset to the company.

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Purpose of Synthetic Lease

• Financial Reporting Operating Lease (OFF
  balance sheet)
• Tax Reporting Loan with deductions for interest
  and depreciation (ON balance sheet)
• WSJ 1999 Synthetic lease transactions help
  companies boost earnings and shed non-core
  assets.

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History of Synthetic Leasing

• First appeared in mid-1980s.
• 100 billion of debt involving over 2,000
  companies is tied up in synthetic lease
  arrangements at December 2001. (The Times)
• Post-Enron Effect companies have started
  reversing synthetic lease arrangements.

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Example Krispy Kreme

• In 2001, financed a new 30 million plant and
  warehouse in Illinois.
• In February 2002 Forbes article Debt? Who Me?
  claimed synthetic leasing is an off-balance
  sheet trick and was critical of Krispy Kreme.
• After the article was released, Krispy Kreme
  reversed its synthetic lease.

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Krispy Kreme Statement

• Scott Livengood, Chairman and CEO in the
  current economic climate, investors
  understandably are paying closer attention to
  financial strength of their companies. There are
  no reasons for us to do anything that could be
  misinterpreted, regardless of how legal and
  acceptable it may be. The perception and
  confidence of investors and customers is more
  important than the propriety of accounting
  vehicles.

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Basic Case Requirements

• 1. Describe advantages and
• disadvantages of synthetic leasing.
• 2. Show accounting entries and
• financial statement presentation for
• both book and tax purposes.
• 3. Discuss pre/post Enron influence on
• synthetic leasing.
• 4. Obtain and evaluate 2 popular press articles
• (WSJ-1999 and Forbes-2002) with opposing
• views of synthetic leasing.

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Discussion Points Basic Case Requirements

• Req. 1 Since GAAP requires footnote disclosure
  of future cash outflows from operating leases,
  are the synthetic lease arrangements truly hidden
  or off-balance sheet?
• Req. 4 After reading WSJ and Forbes articles,
  discuss public perception, Wall Street
  expectations, purpose of accounting rules,
  conservatism in accounting, and public confidence
  in the accounting profession.

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Basic Case Requirement 2Financial Statement
Presentation

• a. See journal entries in solution
• b. Disclosures
• Book
• Balance Sheet (no disclosures)
• Income Statement (rent expense included in
  expenses)
• Disclosures (footnote disclosure of operating
  leases)
• Tax
• Balance Sheet (leased asset and lease obligation)
• Income Statement (depreciation and interest
  expense)
• Disclosures (as necessary on tax return)

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Advanced Case Requirements

• Involve a detailed examination of eBays
  synthetic lease transaction (Appendix A),
  synthetic lease arrangement (Appendix B), and
  financial statement disclosures.
• Students are asked to carefully read and apply
  authoritative lease guidance (Appendix C).

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Advanced Case Requirements

• 1. Review excerpts from eBay lease
• and determine lease classification based upon
  GAAP.
• 2. Compute financial statement ratios.
• 3. Compute PV and recast financial
• statements using different assumptions.
• 4. Compute tax deductions.
• 5. Review GAAP and answer a series of
• questions.

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eBays Synthetic Lease

• On March 1, 2000, eBay constructed office
  facilities in San Jose, CA at a total cost of
  126.4 million. The property was owned by a
  separate entity, eBay Realty Trust and leased to
  eBay.
• Excerpts from the lease (Appendix B) state the
  lease is to be treated as an operating lease for
  financial reporting purposes, and eBay is to be
  treated as the owner of the property for federal
  tax purposes.

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SFAS 13 DeliberationAdvanced Requirement 5b

• The original discussion memorandum listed 14
  criteria for lease classification among them to
  require capitalization if the lessee treats the
  lease as a purchase for tax purposes.
• The FASB rejected this proposal stating There
  are many instances in which tax and financial
  accounting treatments diverge, and the question
  of a possible need for conformity between them is
  beyond the scope of this Statement. (SFAS 13,
  para. 78).

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SFAS 13 DeliberationAdvanced Requirement 5c

• Discuss whether eBay Realty Trust has minimal
  investment in the property and how this affects
  the lease capitalization decision
• The FASB Board finds no justification for
  requiring that the lease be accounted for as a
  capital lease by lessee simply because an
  unrelated lessor lacks independent economic
  substance. In such a case, it probably means
  that someone else, presumably the lender, is in
  substance the lessor, but this circumstance, per
  se, should not alter the lessees accounting.
  Accordingly, the Board rejects this criterion.
  (SFAS 13, para. 82)

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Advanced Tax Considerations

• The IRS examines the purpose of a transaction to
  ensure that the sole intent is not for tax
  avoidance.
• In regards to synthetic leases, the IRS has
  accepted off-balance sheet financing as a
  business purpose. The taxpayer receives the
  advantage of low cost financing that is off its
  balance sheet.

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Classroom Considerations

• Suitable for undergraduate or graduate
  intermediate accounting, tax, or financial
  statement analysis class.
• Case can be covered in a 75 minute class period
  with advance preparation by the students.
• Case can be presented from perspective of
  financial advisor (CPA) or user (analyst).

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Possible Teaching Approaches

• Class Discussion - focus on asymmetric lease
  treatment for book and tax, pre and post Enron
  approach to synthetic leasing, and transparency
  in financial reporting.
• In-Class Team Learning require teams to
  challenge or defend synthetic lease reporting and
  book/tax differences.

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Teaching Aids

• Suggested solutions to both the basic and
  advanced requirements are provided.
• Advanced tax considerations are suggested with
  references to primary tax authority and technical
  articles.

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Future Regulatory Guidance

• SFAS No. 145
• SFAS No. 13
• SPEs (exposure draft)
• Synthetic lease activity
• International Accounting Standards Committee

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Discussion

• Questions or Comments?
• Thank you FSA and AICPA for inviting us!

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Contact Information

• Christine Bauman
• (cbauman_at_uwm.edu)
• Robert Halsey
• (halsey_at_babson.edu)
• Paula Hasbach
• (paula.j.hasbach_at_us.pwcglobal.com)