Operating Leases or Capital Leases - Asset Essay Example

Suppose you were the chief financial officer (CFO) of Southwest Airlines. Southwest leases some of its planes. Suppose the leases can be structured either as operating leases or as capital leases. Which type of lease would you prefer for Southwest? Why? Consider what would happen to Southwest s debt ratio if its operating leases in footnote 8 were capitalized, and the related liabilities recognized.

Computing Southwests debt ratio two ways (operating leases versus reclassifying them as capital leases) will make your decision clear (using Southwest s actual figures in millions): You can see that a capital lease increases the debt ratio by about five percentage points for Southwest, but a lot more for UAL and AMR (parent company of American Airlines). By contrast, notice that operating leases don t affect the debt ratio that’s reported on the balance sheet. For this reason, companies prefer operating leases.

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It is easy to see why Southwests long-term commitment for operating leases, as disclosed in Note 8, far outweighs that of its capital lease agreements. Ethical Challenge Because of the relatively mechanical nature of the accounting criteria for capitalization of leases, it is possible under existing U. S. GAAP to purposely structure a company’s lease agreements so that they barely miss meeting the third criterion (75% test) or the fourth criterion (90% test) for capitalization. Many U. S.

companies have taken advantage of these mechanical rules, quite legally, to their economic advantage, thus obtaining almost all the same economic benefits associated with ownership of long-term assets, but avoiding the detrimental impact that recording those assets and obligations can have on their debt ratios. Pensions and Postretirement Liabilities Most companies have retirement plans for their employees. A pension is employee compensation that will be received during retirement. Companies also provide postretirement benefits, such as medical insurance for retired former employees.

Because employees earn these benefits by their service, the company records pension and retirement-benefit expense while employees work for the company. Pensions are one of the most complex areas of accounting. As employees earn their pensions and the company pays into the pension plan, the plans assets grow. The obligation for future pension payments to employees also accumulates. At the end of each period, the company compares •The fair market value of the assets in the retirement plans cash and investments with •The plans accumulated benefit obligation, which is the present value of promised future payments to retirees.

If the plan assets exceed the accumulated benefit obligation, the plan is said to be overfunded. In this case, the asset and obligation amounts are to be reported only in the notes to the financial statements. However, if the accumulated benefit obligation (the liability) exceeds plan assets, the plan is underfunded, and the company must report the excess liability amount as a long-term liability on the balance sheet. Reference link: http://classof1. com/homework-help/business-management-homework-help

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