1. A
lease is a contractual agree-
ment in which the owner,
or lessor, of an asset, such
as real estate or equipment,
grants the right of usage to
a lessee for a specified amount of time. In
return for the usage right, the lessee pays
the lessor rent over a specified period of
time, known as the term.
Current guidelines for accounting
treatment of leases declare a lease as
either a capital or operating lease. The
Financial Accounting Standard No. 13
(FAS 13) states,“[A] lease that transfers
substantially all of the benefits and risks
incident to the ownership of property
should be accounted for as the acquisi-
tion of an asset and the incurrence of
an obligation by the lessee and as a sale
or financing by the lessor.”1
Companies
follow a set of “bright-line” rules for
classifying leases as either capital leases,
which are reported on the balance sheet
as an asset along with its corresponding
liability, or operating leases, which are
considered “off balance sheet arrange-
ments” for which the corresponding val-
ues are instead disclosed in financial
statement notes.2
Rules-based lease accounting has made
it possible for parties to structure leas-
ing transactions to achieve desired
accounting outcomes.3
These rules-based
criteria have allowed companies to cir-
1MAY/JUNE 2014 INTERNAL AUDITING
EVALUATIONOF
THEIMPACTOF
PROPOSEDCHANGES
TOLEASING
ACCOUNTING
STANDARDSJOH N H . MA RTIN A N D W EI J IA N G
JOHN H. MARTIN ha s over 25 yea rs of working experience from interna tiona l sa les, ma rketing, a nd business ma n-
a gement. He is currently the opera tions ma na ger for Coa stline Equity, Inc., a rea l esta te ma na gement services firm
in Torra nce, CA. He ca n be rea ched a t johnhmar tin@y mail.com.
WEI JIANG is a n a ssocia te professor of a ccounting a t Ca lifornia Sta te University, Fullerton. His prima r y resea rch
interests include fina ncia l reporting qua lity, interna l control, corpora te governa nce, a nd executive compensa tion.
His resea rch findings have been published in Contemporar y Accounting Research, Journal of Banking and Finance,
Advances in Accounting, International Journal of Auditing, Research in Accounting Regulation, a nd a number
of other journa ls. He ca n be rea ched a t wjiang@fuller ton.edu.
..........................................................................
This article examines the impact of proposed lease accounting changes on
assets, liabilities, income, and return on assets for U.S. retailers and airlines.

2. .......................................................................................
cumvent the spirit of the capital lease
designation guidelines. A large majority
of long-term corporate leases are clas-
sified as operating leases, likely due to
the gaming of rules for structuring leases
in order to obtain the operating lease
designation.4
The existing lease account-
ing rules have been criticized for failing
to meet the needs of users of financial
statements because they do not always
provide a faithful representation of leas-
ing transactions.
In fact, the Securities and Exchange
Commission (SEC) identified the need
for changes in lease reporting in its 2005
report to Congress as required by the
Sarbanes–Oxley Act of 2002. It deter-
mined that, among SEC registrants, off
balance sheet lease obligations totaled 31
times the amount of on balance sheet
obligations.5
A portion of these off bal-
ance sheet arrangements were operat-
ing leases.
The Financial Accounting Standards
Board (FASB) and the International Secu-
rity Advisory Board (ISAB) commenced
the joint project in 2006. In 2010, the
FASB released the exposure draft “Pro-
posed Accounting Standards Update:
Leases (Topic 840),” which relates to FAS
13 issued in 1976 and provides guidance
for lessees and lessors in recognizing,
measuring, and presenting assets and
liabilities from leases.6
As a follow-up,
on May 16, 2013, the FASB also released
“Proposed Accounting Standards Update:
Leases (Topic 842).”7
The FASB and the
ISAB plan to consider interested par-
ties’ feedback and begin re-deliberations
of all significant issues in the first quar-
ter of 2014 to finalize the rules. Imple-
mentation of these approved changes
will most likely not be required before
2016.
The stated objective of the FASB is to
“establish principles that lessees and
lessors shall apply to report relevant and
representationally faithful information
to users of financial statements about
the amounts, timing and uncertainty of
the cash flows arising from leases.” The
FASB exposure draft defines a lease as “a
contract in which the rights to use a
specified asset or assets is conveyed, for
a period of time, in exchange for con-
sideration.”8
The exposure draft pro-
poses that lessees and lessors should
apply a right-of-use model in account-
ing for most leases and that lessees and
lessors should present the assets, liabil-
2 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION
EXHIBIT 1 Financial Statement Data

3. ities, income, expenses, and cash flows
arising from leases separately from other
assets, liabilities, income, expenses, and
cash flows.9
Lessees most affected by the proposed
changes would be those with a majority
of their property leases classified as long-
term operating leases, which is a com-
mon practice in the retail and airline
industries. The requirement that nearly
all leases be treated as capital leases
would likely result in a material change
in balance sheet account valuations and
in key measures of financial performance.
In this study, we empirically examine
the impact of the proposed lease account-
ing changes on assets, liabilities, income,
and return on assets (ROA) for the 10
largest retailers and five largest airlines
in the United States. For illustration pur-
poses, we focus on changes in the first
year following conversion. While lease
capitalization will increase asset and lia-
bility reporting on balance sheets, we
expect net income and ROA to be neg-
atively affected by the conversion. While
the direction of the change is easy to
predict, the degree of change is unknown.
The purpose of this study is to provide
an assessment of the magnitude of the
potential changes as well as to deter-
mine which companies in a particular
industry will be most affected by the
changes when compared to their peers.
Exhibit 1 presents the basic financial
statement data required for conversion.
All data are collected from firms’ 10-K
reports for fiscal year 2012. Reclassifying
operating leases as capital leases requires
making assumptions about time remain-
ing on individual leases, the actual inter-
est rate used in the lease agreement with
the lessor, and the effective interest rate
used by the company in its debt obliga-
tions, which are not readily available from
financial statements. The assumptions
and research methodologies used in this
article follow prior accounting literature,
textbooks, and practice.10
An examination of the company data
shows that both industries make extensive
use of operating leases, with 88 percent
and 89 percent of the total leases being com-
prised of operating leases for retailers and
airlines, respectively. The airline indus-
try, however, is less profitable and generates
lower revenue than the retail industry
($36.8 million versus $101.6 million).
Intense competition among airline com-
panies in recent years has driven up cap-
ital and operating costs and cut into profits.
By similar reasoning, airline companies
are generally assigned lower debt ratings
by Moody’s.11
3LEASE CAPITALIZATION MAY/JUNE 2014 INTERNAL AUDITING
............................................................................................
EXHIBIT 2 Balance Sheet Adjustments

4. Balance sheet adjustments
Panel A of Exhibit 2 presents the changes
in assets and liabilities after converting
existing operating lease obligations into
capital lease accounting treatment for
companies in the retail industr y. As
expected, all companies experience a
significant increase in both assets and lia-
bilities. The range of increase for assets
is a low of 6.31 percent for Target and a
high of 95.29 percent for Walgreens with
an average industry increase of 26.37
percent. The increases in liabilities are
even higher, ranging from 9.25 percent
for Target to 191 percent for Walgreens
with an average industr y increase of
46.90 percent. Note that there is a direct
relationship between the percentage of
current operating leases and the changes
in assets and liabilities: the lower the
number of operating leases required to
be converted, the smaller the change in
the asset/liability valuation. Of the 10 retail-
ers in our sample, Target has the small-
est number of operating leases in need
of conversion at 47 percent, while Wal-
greens has 99 percent of its lease oblig-
ations currently classified as operating
leases. This explains why Walgreens
exhibits a significantly higher increase
in both assets and liabilities than Target.
The results for the airline industry are
displayed in Panel B of Exhibit 2. The air-
line industry averages an increase of
30.83 percent in assets and 31.45 percent
in liabilities. The range of increase for
assets was a low of 21.02 percent for
Southwest and a high of 42.6 percent for
US Airways. Despite its fleet size being
the third largest, Southwest has the low-
est future operating lease obligations
among all airlines (see Exhibit 1) and
therefore would be the least affected by
lease capitalization. In comparison,
although the dollar amount of future
lease obligations for US Airways is sec-
ond to last behind Southwest, it also has
the smallest declared asset valuation
amount prior to conversion. The abnor-
mally low asset basis raises the likeli-
hood that a relatively small absolute
increase in asset value would produce a
disproportionately large percentage
increase. As for the changes in liabilities,
US Airways continues to rank the high-
est with an increase of 43.88 percent.
Delta, on the other hand, replaces South-
west to post the smallest increase in lia-
bilities at 21.09 percent. This is principally
due to the fact that Delta’s liabilities
prior to the conversion are extremely
high, hence mitigating the effect of any
4 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION
..........................................................................................
EXHIBIT 3 Income Statement and Return on Assets Adjustments

5. .......................................................................................................................................................
increase in liabilities on a percentage
change basis.
Income statement adjustments
We next examine the effect of lease cap-
italization on income. The results are
reported in Exhibit 3. Consistent with our
expectations, all sample firms experi-
ence a reduction in income with an aver-
age decline of 24.34 percent and 55.75
percent for retailers and airlines, respec-
tively. The average reduction is greater
than the prediction put forth by the
Equipment Leasing and Finance Foun-
dation study, which projects a 2.4 per-
cent decrease in pre-tax net income.12
This is primarily due to retail and air-
line sectors having a greater proportion
of operating leases than other indus-
tries, as shown in Exhibit 1.
Within the retail group, Target’s income
decreases the least by just 2.25 percent.
At 47 percent, Target has by far the low-
est amount of current lease obligations
classified as operating leases. A general
rule is that the lower the number of oper-
ating leases in need of conversion, the
smaller the negative effect on reported
income. Best Buy, on the other hand,
takes the greatest loss in income with a
decrease of 64.88 percent. While the per-
centage of operating lease obligations
for Best Buy is below the industry aver-
age at 87 percent, two additional factors
contribute to the large income reduc-
tion. Best Buy has the highest imputed
interest rate and shortest lease term
among all retailers in this study. Higher
discount rates and shorter periods
remaining on lease obligations gener-
ally translate into greater income reduc-
tion when operating leases are converted
into capital leases. The short time remain-
ing on Best Buy’s estimated lease term
is likely intentional due to its declining
revenues and uncertain future. In other
words, they will not be opening new
stores or intending to renew options on
existing leases that will soon expire due
to the uncertainty of its current busi-
ness model as a big box retailer in the con-
sumer electronics sector.
Turning to the airline sector, it appears
that the effect of lease capitalization on
income is more volatile. Its reduction
in operation income ranges from a low
of 19.10 percent for American Airlines
to a high of 108.58 percent for United
Continental with an average drop of 55
percent. In comparison to the retail in-
dustry, the airline industry has rela-
tively larger operating lease commit-
ments and lower revenues (see Exhibit 1),
hence resulting in a far greater percen-
tage change in income after converting
operating leases to capital leases. In
addition, the airline industry on aver-
age carries a lower debt rating as assigned
by Moody’s due to greater earnings fluc-
tuations (see Exhibit 1). A lower debt rat-
ing translates into higher imputed interest
expense under capital and lower income,
and everything else is equal. All of these
factors contribute to the greater income
loss for the airline industry as a result
of lease capitalization.
ROA adjustments
A key financial ratio often cited by ana-
lysts in assessing a company’s profitability
is the return on assets (ROA). Compa-
nies are expected to experience a reduc-
tion in their ROAs due to increasing asset
valuation and decreasing income for all
companies. The results reported in
Exhibit 3 support this conjecture. Within
the retailer group, the lowest loss in ROA
is Target at 0.52 percent, with a decline
from 6.48 percent to 5.96 percent. The
greatest reduction is experienced by Wal-
greens at 5.66 percent, a drop from 6.98
percent to 1.32 percent. These results
are consistent with Target and Walgreens
having the smallest and largest increases
in asset valuation after the conversion,
respectively.
Similarly, all but one of the airlines have
a reduction in their ROA, with US Air-
ways and United Continental exhibiting
the largest and smallest declines of 4.33
percent and 1.04 percent, respectively.
American Airlines actually experiences
a small increase of 0.86 percent in ROA.
This anomaly is due to the company
reporting negative equity as a result of
continuous operating losses.
In summary, this study provides con-
sistent evidence of the effects of lease
5LEASE CAPITALIZATION MAY/JUNE 2014 INTERNAL AUDITING

6. .......................................................................................................................................................
capitalization on a variety of financial
statement items and financial ratios
across companies and industries in the
first year after the accounting treatment
conversion. Our results suggest that a
company carrying large operating lease
obligations relative to its capital lease
obligations or ownership of its assets
will be most affected by the conversion.
The magnitude of the change also varies
depending on factors such as debt rat-
ing and lease term. Given that both indus-
tries make extensive use of operating
leases, the effects of conversion on fi-
nancial and operating results could be
significant enough to elicit negative reac-
tions from creditors and investors. For
example, the disproportionately large
percentage increase in liabilities rela-
tive to assets could lead to a substantial
increase in the debt ratio. In the case of
Walgreens, the combination of a 95.29
percent increase in assets and a 190.63
percent increase in liabilities would give
rise to a 49 percent increase in the debt
ratio, which could raise concerns about
potential violations of loan covenants.
Similarly, a nearly 64 percent drop in
Walgreens net income could potentially
trigger steep declines in stock price.
Looking ahead, should the FASB suc-
ceed in getting these proposed standard
updates implemented as they are cur-
rently written, it would benefit the cap-
ital market community if a public
awareness campaign were launched edu-
cating financial statement readers of the
effects of these changes in accounting
treatment of lease obligations and of the
anticipated reductions in income and
other key metrics. Without adequately
informing the shareholders of these
changes in accounting procedures, share-
holders may misinterpret the post-con-
version results and promptly sell off
shares, resulting in a rapid and signifi-
cant loss of capital. n
NOTES
1
“Statement of Financial Accounting Standards No.
13, accounting for leases, original pronouncements
as amended,” Financial Accounting Standards Board
(2008). Available at: http://www.fasb.org/st/.
2
Specifically, in order to be considered a capital
lease the arrangement must meet any of the four
following “bright-line” criteria: 1) the lease contains
a transfer of ownership at the end of the lease
term; 2) the lease contains a bargain purchase
option; 3) the lease term is equal to 75 percent or
more of the asset’s remaining useful life; or 4) the
present value of the minimum lease payments is
equal to 90 percent or more of the asset’s fair mar-
ket value. Criteria 3 and 4 are not applicable to an
asset leased in the last 25 percent of its total life
span. The term “bright-line,” with respect to rules
or guidelines, refers to rules that are clearly stated,
leaving no room for varying interpretations.
3
“FASB formally adds project to reconsider lease
accounting,” Financial Accounting Standards Board
(July 19, 2006). Available at: http://www.fasb.org/
news/nr071906.shtml (accessed March 3, 2013).
4
Sophisticated users of financial statements as they
are currently comprised will often manually adjust
the liability figures via estimation in order to account
for the off balance sheet obligations currently
reported only via the disclosures.
5
“2005 performance and accountability report,” U.S.
Securities and Exchange Commission (2005). Avail-
able at: http://www.sec.gov/about/secpar/sec-
par2005.pdf.
6
“Proposed accounting standards update: Leases
(Topic 840),” Financial Accounting Standards Board
(2010). Available at: http://www.fasb.org.
7
“Proposed accounting standards update (revised):
Leases (Topic 842),” Financial Accounting Stan-
dards Board (2013). Available at: http://www.fasb.org
8
Ibid., Appendix A, paragraphs B1–B4 and BC29–BC32.
9
Op. cit. note 6, paragraphs 25–27, 42–25, 60–63,
and BC142–BC159.
10
Details about the assumptions and methodologies
are available upon request.
11
Moody’s debt ratings are used to estimate the
imputed interested rate, a major input into the cal-
culation of the net present value of a capital lease.
12
“Economic impacts of the proposed changes to
lease accounting standards,” Equipment Leasing
& Finance Foundation (Dec 12, 2011). Available at:
http://www.leasefoundation.org/IndRsrcs/MO/Lse
Acctg/.
6 INTERNAL AUDITING MAY/JUNE 2014 LEASE CAPITALIZATION