Capitalizing Operating Leases is not GAAP

Par. 5. The Accounting Principles …agrees that the nature of some lease agreements is such that an asset and a related liability should be shown in the balance sheet, and that it is important to distinguish this type of lease from other leases. The Board believes, however, that the distinction depends on the issue of whether or not the lease is in substance a purchase of the property rather than on the issue of whether or not a property right exists….

Par. 7. It seems clear that leases covering merely the right to use property in exchange for future rental payments do not create an equity in the property and are thus nothing more than executory contracts requiring continuing performance on the part of both the lessor and the lessee for the full period covered by the leases. The question of whether assets and liabilities should be recorded in connection with leases of this type is, therefore, part of the larger issue of whether the rights and obligations that exist under executory contracts in general (e.g., purchase commitments and employment contracts) give rise to assets and liabilities which should be recorded.

Par. 8. The rights and obligations related to unperformed portions of executory contracts are not recognized as assets and liabilities in financial statements under generally accepted accounting principles as presently understood. Generally accepted accounting principles require the disclosure of the rights and obligations under executory contracts in separate schedules or notes to the financial statements if the omission of this information would tend to make the financial statements misleading.

"Here they are for lessees: the balance sheet does not report an asset or a liability [emphasis added, GP] (while the liability can be estimated, the asset’s value cannot), the income statement uses rent expense in computing operating income instead of depreciation and interest, thereby misrepresenting what really happened and making EBITDA calculations meaningless, the statement of cash flows understates cash from operations and understates cash used for financing, and the footnotes are incomplete and nearly useless.

"As to Mr. Pugh’s suggestion that FASB and the SEC don’t understand financial analysis, I question his conclusion. I have worked at both places and have watched their members and staffs evolve over the years. They are very much in tune with the needs of financial statement users, so the suggestion to the contrary simply makes me scratch my head."

Summary: This Statement encourages enterprises to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method).

Effective Date [1988] and Transition para. 34. Messrs. Lauver and Swieringa also dissent to this Statement's permitted use of the indirect method of reporting net cash flow from operating activities. They believe that by permitting the continued use of the indirect method, the Board has foregone the opportunity to make a significant contribution to the quality of financial reporting and to enhanced user understanding of cash flows from operating activities.

111. A majority of respondents to the Exposure Draft asked the Board to require use of the direct method. Those respondents, most of whom were commercial lenders, generally said that amounts of operating cash receipts and payments are particularly important in assessing an enterprise's external borrowing needs and its ability to repay borrowings.