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Book and Tax Considerations in Off-Balance Sheet Leases

2. Co-Authors. Christine Bauman, Assistant ProfessorUniversity of Wisconsin-MilwaukeeRobert Halsey, Assistant ProfessorBabson CollegePaula Hasbach, Senior Tax ManagerPricewaterhouseCoopers, LLP. 3. Motivation. The synthetic lease industry was thriving until December 2001 when Enron coll

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Book and Tax Considerations in Off-Balance Sheet Leases

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    1. Book and Tax Considerations in Off-Balance Sheet Leases 2002 AICPA Professor/Practitioner Case Development Program *Special thanks to Professor Silvia Madeo for helpful comments.

    2. 2 Co-Authors Christine Bauman, Assistant Professor University of Wisconsin-Milwaukee Robert Halsey, Assistant Professor Babson College Paula Hasbach, Senior Tax Manager PricewaterhouseCoopers, LLP

    3. 3 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.

    4. 4 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

    5. 5 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.

    6. 6 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.

    7. 7 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.

    8. 8 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.

    9. 9 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.

    10. 10 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.

    11. 11 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.

    12. 12 Basic Case Requirement 2 Financial 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)

    13. 13 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).

    14. 14 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.

    15. 15 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.

    16. 16 SFAS 13 Deliberation Advanced 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).

    17. 17 SFAS 13 Deliberation Advanced 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)

    18. 18 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.

    19. 19 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).

    20. 20 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.

    21. 21 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.

    22. 22 Future Regulatory Guidance SFAS No. 145 SFAS No. 13 SPEs (exposure draft) Synthetic lease activity International Accounting Standards Committee

    23. 23 Discussion Questions or Comments? Thank you FSA and AICPA for inviting us!

    24. 24 Contact Information Christine Bauman (cbauman@uwm.edu) Robert Halsey (halsey@babson.edu) Paula Hasbach (paula.j.hasbach@us.pwcglobal.com)

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