The Role of Interpretation in the Implementation of FAS 13 The test set forth in FAS 13 may suggest that the lessee cannot influence

The Role of Interpretation in the Implementation of FAS 13 The test set forth in FAS 13 may suggest that the lessee cannot influence

the classification of a lease. Every accountant knows how to classify a lease given the required information about the lease. But there’s the rub! All but the first criterion, transfer of ownership by the end of the lease term, require sufficient judgment by the individual gathering the data

that can influence the classification. 4 Let’s look at Criterion 2 and 3 to see how this is possible. Criterion 2 involves the existence of a bargain purchase price. To say that an option to purchase some asset at a future date is a bargain purchase requires judgment as to the expected projected fair market value at the exercise date. What you may perceive as a bargain purchase given your projected fair market value may not be a bargain to another individual who has determined a different projected fair market value for the same product. We constantly observe differences of opinion of projected future values in the marketplace for equipment. The person responsible for gathering the data must resolve whether a bargain pur- chase option exists.

4 Dan Palmon and Michael Kwatinetz, “The Significant Role Interpretation Plays in the Implementation of SFAS No. 13.” Journal of Accounting, Auditing & Finance

(Spring 1980).

SELECTED TOPICS IN FINANCIAL MANAGEMENT

Even if the projected fair market value could be estimated with some degree of certainty, internally or externally from expert appraisers, judgment is still required to determine whether it is a bargain. Is the option to buy a leased asset for $15 million five years from now when the projected fair market value has been estimated to be $15.2 million a bargain? To resolve this question, management must specify criteria for the presence of a bargain purchase. An extreme case would categorize a bargain purchase when the option price is less than the projected fair market value. More than likely, management will arbitrarily set a mini- mum percentage for the purchase option price to the projected fair mar- ket value. What seems to be a very simple criterion can now be seen to require considerable judgment by management and the individual desig- nated to gather the information.

Criteria 3 classifies a lease as a capital lease if the lease term is 75% or more of the estimated economic life of the leased asset. At first, it may appear that the lease term is readily available from the lease agree- ment but that judgment is required to estimate the economic life. In fact, both permit managerial discretion in implementation in the absence of a bargain purchase option. When a bargain purchase option exists, the lease term is defined as the period between the inception of the lease and the date on which the bargain purchase option becomes exercisable. The lease agreement may permit additional lease periods so the lease term may not be clear.

The problems associated with estimating the economic life of the leased asset are the same as those experienced by management when estimating the economic life of owned assets it must depreciate. For cer- tain types of assets, this task may not be difficult because of company or industry experience. For other assets, different estimates may exist for the same asset. Lengthening the estimated economic life will influence the outcome of Criterion 3 for classification.