THE IMPACT OF LEASES ON FINANCIAL ANALYSIS Thesis gov {he Dogma 9‘ pk. D. WCHXGAN STATE UNIVERSITY Andrew Thomas Nelson 19 6 2 [fit-.950 This is to certify that the thesis entitled THE IMPACT OF LEASES ON FINANCIAL ANALYSIS presented by Andrew Thomas Nelson has been accepted towards fulfillment of the requirements for Ph. D. degree in Accounting % /(,<7 2/ I/(//’% Major professor ./ / 4937-; 0n 4/?) Date 1 . I - / / 0-169 L I B R A Michigan Univers 4-.. Ff4._ '- ABSTRACT THE IMPACT OF LEASES ON FINANCIAL ANALYSIS by Andrew Thomas Nelson Leasing has experienced a tremendous growth in recent years. This growth has been accompanied by a fundamental change in the nature of the lease transaction. It is no longer solely a means of obtaining services but is now also an important means of financing. The advent of the "financial" lease has given rise to some very important accounting problems, the solution of which will have a profound effect on the entire business world. These problems hinge on current reporting practices which provide for disclosure of leases in the body of the financial statements only to the extent that the rentals have been paid or accrued. As a result of this practice, assets which are obtained through lease financing are omitted from the lessee's balance sheet. Likewise, the liabilities which give rise to these assets are not shown in the financial statements. While this practice is probably adequate for "service" leases, it ignores the economic and financial fact that "financial" leases are in reality means of financing which are similar to conventional debt. A number of proposals for correcting these deficiencies have already been made. The purpose of this thesis is to determine the impact that the various proposals for reporting leases have upon con- ventional financial analysis. An answer to this problem is necessary in order to evaluate fairly the available alternatives. Andrew Thomas Nelson The study is divided into five phases. First, the advantages and disadvantages of leasing are reviewed in order to expose artificial advantages and determine the extent to which accounting has contributed to their existence. Second, the extent and nature of current financial statement reporting is examined in order to gain an understanding of the underlying problem. Third, the proposed changes in financial statement reporting are examined with special attention being directed to the capitalization proposal. Fourth, the leases of eleven corporations are capitalized and the financial statements reconstructed to reflect these amounts. Finally, fifteen different financial ratios are computed for each of the eleven lessee firms both before and after capitalization. An evaluation is then made of each of these ratios to determine whether or not they are improved by capitalization. Major findings of the study include: 1. Current techniques for reporting of “financial" leases are not adequate in that they fail to recognize important financial and economic facts. 2. Current reporting does not provide sufficient detail to enable the financial analyst accurately to capitalize leases. 3. Much of the case presented in favor of leasing rests upon "illusory" arguments which are based upon faulty reporting techniques. 4. Capitalization of lease rentals with the amounts included in the balance sheet totals is the only proposal examined that can satisfactorily overcome the deficiencies in current reporting. 5. Capitalization is deeply rooted in accounting theory and com- pletely compatible with currentprinciples of accounting. 6. Most of the ratios affected by leasing are made more meaning- ful by capitalization. In fact, ratios that are computed from conventional Andrew Thomas Nelson financial statements are misleading and may result in faulty decisions. 7. Through capitalization most of the financial ratios analyzed will make a lessee firm's weak financial position apparent whereas without capitalization this fact may remain concealed. Copyright by ANDREW THOMAS NELSON 1962 THE IMPACT OF LEASES ON FINANCIAL ANALYSIS BY Andrew Thomas Nelson A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1962 ACKNOWLEDGMENTS The author wishes to express his sincere thanks to his doctoral committee, who have assisted greatly in the preparation of this disser- tation. Dr. Charles Lawrence, who served as committee chairman, and Dr. Robert W. Johnson and Dr. William J. E. Crissy, who served as committee members, each provided valuable assistance and en- couragement throughout the study. The writer is indebted to Dr. James Don Edwards and the Department of Accounting and Financial Administration for providing financial aid, physical facilities, and an outstanding faculty, all of which have made an immeasurable contribution. The American Accounting Association, the Mortgage Bankers Association, the Uni- versity of Utah, and others have also contributed financial assistance which has been extremely helpful. I am most grateful to those whose unselfish sacrifice and con- stant encouragement have made this task possible: to my wife and sweetheart, Nadine; to our precious children; and to my beloved parents--all of whom had faith that I could do the job. Finally, I am grateful to my Heavenly Father for providing me the opportunity, the clear mind, and the healthy body to accomplish this task. >:< :1: >1: at: >',< a}: 3:: >:< >§< * a}: 2:: :‘,< >1: >:< :3 ii CHAPTER II. III. IV. TABLE OF CONTENTS Page THE IMPACT OF LEASES ON FINANCIAL ANALYSIS . . 1 Significance of the Problem . . . 1 The Problem Defined . . . 2 Scope of the Study . . . 3 Approach to the Problem . 4 BACKGROUND . 6 The Growth of Leasing 6 Types of Leases . . . . 8 The Financial Lease. . . . . . . . . 10 Advantages and Disadvantages of Leasing 14 EXTENT AND NATURE OF CURRENT FINANCIAL STATEMENT REPORTING . Nature of Current Reporting . . ...... Causes of Apparent Deficiencies ..... Rationale Behind Current Practices PROPOSED CHANGES IN FINANCIAL STATE- MENT REPORTING . Proposed Changes . . . ..... Rationale Behind Capitalization . The Capitalization Controversy . METHODOLOGY . Selection of Companies . . . ....... Determination of Rental Schedules Selection of Interest Rates Capitalization of Leases. . . iii 39 39 51 53 59 59 69 79 95 95 98 100 105 TABLE OF CONTENTS - Continued CHAPTER Page VI. THE IMPACT OF CAPITALIZATION ON FINANCIAL RATIOS ....... . . . . . . . . ...... . 106 Limitations of Ratios . . . . . . . . . . . . . . . 107 Selection of Ratios . . . . . . . . . ....... 108 The Impact of Capitalization ...... . . . . . 123 VII. SUMMARY AND CONCLUSIONS . . . . ..... . . 135 Summary . . . . . . . . . . . . ....... . . 135 Conclusions. . . . . . . . . . . . . . . . . . . . 139 BIBLIOGRAPHY . . . . . . . . ..... . . . . . . . . . . . . 142 APPENDIXES . . . . . ...... . . . . . . . . . . . . . . . 154 iv LIST OF EXHIBITS EXHIBIT 1. Comparison of Lease Plan with Cash Purchase. 2. Projected Earnings on Capital Freed by Leasing as Compared with Cash Purchase. . . . . . . . 3. Comparison of Lease Plan with Conditional Sales Contract.................... 4. Projected Earnings on Capital Freed by Leasing as Compared with Conditional Sales Contract . 5. Comparison of Lease Plan with 75% Bank Loan. 6. Projected Earnings on Capital Freed by Leasing as Compared with 75% Bank Loan. . 7. Comparison of Lease Plan with Bank Loan in Acquiring Equipment. . . . . . . . . . 8. Projected Earnings on Capital Freed by Ownership with Bank Financing Compared with Leasing. 9. Disclosure of Long-Term Leases by Lessees. . . 10. Number of Lessee Companies Disclosing Long-Term Leases in Published Financial Statements. . 11. Percentage of Lessee Companies Disclosing Long- Term Leases in Published Financial Statements. . 12. Evaluation of Compliance with A. I. C. P.A. Research Bulletins Regarding Reporting of Long-Term Leases 13. Schedule of Material Contractual Commitments. . 14. Fairbanks Whitney Corporation and Subsidiaries--Con- solidated Balance Sheet. . . . . . . . . . . . . . Page 27 28 29 30 31 32 35 36 4O 46 47 54 6O 63 LIST OF EXHIBITS - Continued EXHIBIT 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. Journal Entries Required Under Capitalized XYZ Company Lease. . . . . . . . . . . ..... Comparison of Similar Lease and Bond Provisions . . Estimated Extent to Which Formal Procedures are Employed for Recognizing Long-Term Leases. Present Value of a Lease Calling for $10, 000 Annual Rental. Percentage Error Incurred by Selection of Improper Interest Rate . Illustration of Financial Leverage . Cash Budget. . . Ratios Affected by Capitalization for Eleven Selected Companies. The Impact of Capitalization on Selected Financial Ratios. . Ranking of Lessee Companies by Ratio Before and After Capitalization vi Page 70 76 91 104 104 115 124 127 130 LIST OF APPENDIXES APPENDIX I. II. III . IV. VI. LIST OF 44 LESSEE COMPANIES ...... SCHEDULE OF LEASE RENTALS . . ....... FINANCIAL STATEMENTS OF 11 SELECTED COMPANIES ................ CHAPTER 14 OF BULLETIN 43-—DISCLOSURE OF LONG-TERM LEASES IN FINANCIAL STATE;- MENTS OF LESSEES ................. DEBT AND LEASE RESTRICTIONS IN CREDIT AGREEMENTS OF MAJOR AIRLINES . . . . LEASE AGREEMENT ..... vii Page 155 158 169 196 199 206 CHAPTER I THE IMPACT OF LEASES ON FINANCIAL ANALYSIS Significance of the Problem Leasing is not a modern day innovation. In fact, the practice actually dates back for hundreds of years before Christ.l For centuries the lease was used almost exclusively in connection with agricultural land. It was a tool which enabled the ruling class to retain control of vast estates, benefit from the land's production, and yet be freed from the problems associated with the actual farming operations. With the coming of the industrial revolution and the urbanization movement which accompanied it, the lease was extended beyond its initial bounds. 1 Many of the commercial buildings constructed during this period of early urban development were built on land which was made available under long-term leases. Even in the cities, however, the lease was confined primarily to transactions involving land and represented a rather insignificant part of our economy. f Today leasing is growing at an accelerated pace and is pervading all facets of the American economy as an alternative to purchasing. Indeed, today it is difficult to find a capital good which is not available through leasing should the customer desire it.2 This growth has been 1Stanley L.. McMichael and Paul T. Q'Keefe, Leases--Percentage, Short and Long-Term (5th ed.; Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1959). p. 1. 2‘It has been reported recently, for example, that many large companies are now leasing tires and tubes for their fleets of company cars..See Fred J. Busko, "Leased Tires Inventory, " N.A.A. Bulletin, Vol. XLI (October, 1959), p. 24. accompanied by a fundamental change in the nature of the lease transaction. It is no longer solely a means of acquiring property which is not available by other legal means but has now become an important means of financing. The present study then is prompted by two factors: first, the accelerated growth in leasing which is making this a subject. of widespread interest to virtually every segment of the economy; and second, the changing nature of the lease transaction. The Problem Defined In spite of these very significant changes in the nature and im~ portance of leasing, the accounting profession has continued to record and report these transactions in the traditional manner. Conventional accounting has provided for the recognition of lease rentals only to the extent that they have been paid or accrued. As a result of this practice, the assets used by companies which have been obtained through lease financing have been omitted from their balance sheets. Likewise, the liabilities which have given rise to the funds necessary to obtain the use of these assets have not been shown in the financial statements. A great deal has already been written on the subject of accounting for long-term leases. This thesis is directed at one major problem which as yet remains unanswered: What impact would the various pro- posals for reportingleases have upon conventional financial analysis ? After all, we must have an understanding of the impact of any proposal before we can attempt to reach a decision on its merits. The question of impact naturally raises some other important questions to which a portion of this study will be directed, such as: 1. What are the various types of leases? 2. How are each of these types reported under current practices ? 3. What types of leases require different treatment than is currently being provided? 4. What are the alternatives to current methods? 5. Which of these methods would produce the most meaningful results from the standpoint of financial analysis ? 6. Have reporting practices contributed to ”illusions" which have resulted in the misuse of lease financing? Scope of the Study A number of limitations in the scope of the study have been made in order tobound the problem in workable form and to bring the study within reasonable limits. First of all, the present study is limited to problems associated with lessee firms. No attempt has been made specifically to determine the possible impact that these proposals might have on the lessors° Second, the study is limited to long-term leases. The meaning of "long-term leases, " of course, varies with one's time perspective. One writer has defined them as leases which extend for "twenty-one 1 On the other hand, the American Institute of Certified years or more. " Public Accountants has used the expression "long-term leases" to cover those leases which extend beyond three years.2 This latter meaning is the one used here, although this is strictly an arbitrary decision. Third, in appraising the impact upon financial analysis we will be primarily concerned with the financial ratios. Obviously there are other important means of financial analysis. However, each of the commonly used ratios directs attention to the firm's financial statements. Since the ratios themselves are computed from the financial statements, lMclVlichael and O'Keefe, 23. 313., p. 92. zAmerican Institute of Certified Public Accountants, Accounting Research and Terminology Bulletins. (Final edition; New York: Ameri- can Institute of Certified Public Accountants, 1961), p. 126. any study which measures the impact of a factor {in this case, long-term leasing) on financial ratios will to a large extent measure the impact on the underlying financial statements. Fourth, the study is confined to an examination of the problems associated with leasing and does not cover the broader problem of account» ing for other contractual commitments; such as, contracts for the purchase of materials or employment contracts. Additional restrictions will be placed on the study because of the limited data available. These will be discussed later in the thesis as the problems which give rise to these additional restrictions are presented. None of the limitations in the scope of this study is meant to imply that all matters of significance lie within the problem area. Nor are they intended to imply that the conclusions reached have no application to areas excluded from this study. On the contrary, it is hoped that this thesis will stimulate further investigation into other important areas and that the conclusions reached here may have broader application than to this specific problem. Approach to the Problem A background to the problem of accounting for long-term leases is presented in Chapter II. First of all, the two factors which make this problem one of major importance are discussed; namely, the growth of leasing and the changing nature of the lease transaction. This is followed by a presentation of the advantages and disadvantages of leasing, an attempt being made to expose and point up artificial advan- tages and determine the extent to which accounting has contributed to their existence. The purpose of Chapter III is to gain an understanding of current techniques so that they may be evaluated in light of other alternatives. The current reporting techniques are examined in connection with the requirements for reporting that have been established by the American Institute of Certified Public Accountants and the Securities and Exchange Commission. Deficiencies in current reporting are then analyzed in an attempt to determine the causes of these inadequacies. The final section of this chapter is devoted to the rationale behind current practices. The proposed changes in financial statement reporting are examined in Chapter IV. The first topic of discussion is thethree major proposals for revising current reporting: through a supplementary schedule, through capitalization with the amounts shown short, or through capitali- zation with the amounts included in the totals. After discarding the first two proposals, attention is focused on the last one. The rationale behind the capitalization proposal as it has evolved from accounting theory is discussed next. The final section of this chapter will be centered around the capitalization controversy and the development of capitalization. The methodology followed in the analysis of capitalization and current reporting is presented in Chapter V. The method by which the companies which were analyzed were selected, the determination of the rental schedules used, the selection of the appropriate rate of interest, and other problems associated with capitalization are presented. In Chapter VI the impact of capitalization on conventional financial ratios is appraised. To begin with, the limitations of financial analysis are discussed. This is followed by a brief discussion of the objectives of each ratio selected for analysis. The ratios before and after capital- ization are presented next, and an attempt is made to determine which way the ratios come nearest to meeting their objectives. The findings of the study are summarized and the conclusions presented in the final chapter. CHAPTER II BAC KGROUND The Growth of Leasing It is difficult to estimate the volume of lease transactions because there is no central organization which gathers data from the wide variety of firms engaged in the leasing business. However, a person can get some idea of the rate at which leasing is growing by taking a look at the capital equipment under lease. It has been estimated that in 1953 the total amount of capital equipment under lease was about $450 million and that by 1958 the amount had grown to about $1. 5 billion.1 This means that capital equipment leasing grew over 300 per cent during this five-year period. There are indications that leasing may grow at an even faster rate in the future. Leasing has also grown rapidly in the real estate field. The type of transaction which has probably accounted for the largest part of this growth has been the sale-and-lease-back agreement. This type of transaction is usually designed so that the user of the property either purchases or constructs the asset to its own specifications and needs. Upon completion of construction, the asset is sold to a second party under an agreement which provides for the lease of the property back to the party desiring its use. Although the sale-and-lease-back transaction is probably not new, it has only come into wide usage since the second world war. The first lFrancis T. Knouss, "You Can Rent It--But Should You?" N.A.A. Bulletin, Vol. XLI (October, 1959), p. 80. important sale-and-lease-back agreement was executed in 1936 by the Safeway Stores.1 Since that time Safeway has continued to use the lease as a primary tool for expansion. In its 1960 annual report the company reported 2, 904 property leases with minimum annual rentals of approximately $43 million.2 Since the second world war, the saleuandulease—back transaction has increased in frequency and magnitude. For example, in a single transaction which occurred in 1945, the Allied Stores Corporation sold land, buildings and equipment valued at approximately $16 million (net of depreciation) to the Real Property Corporation.3 This sale was accompanied by an agreement which provided for the lease of all of the properties back to Allied or its subsidiaries for a thirtyu-year period with annual rentals totaling over $26 million. Many other com- panies have since made use of this type of transaction. The leasing of real estate is particularly significant in the retail merchandising and grocery fields. Many retail stores of the large chains are occupied under long-term lease agreements. At January 31, 1961, Sears, Roebuck and Company reported "a number" of long- term leases with minimum fixed rentals of $23, 417, 000 .EEE 3&4 F. W. Woolworth Company reported at December 31, 1960, minimum annual rentals for leased property of approximately $44, 300, 000.5 At February 1, 1961, the Montgomery Ward and Company, Inc. , lAlbert H. Cohen, Long-term Leases: Problems of Taxation, Finance and Accounting (Ann Arbor, Michigan: University of Nlichigan Press, 1954), p. 22. ZSafeway Stores, Inc., Annual Report, December 31, 1960, p. 18. 3Cohen, (_)_p_. 93., p. 25. ésearS, Roebuck and Company, Annual R6130”, January 31’ 1961’ p. 27. 5F. W. Woolworth and Company, Annual Report, December 31, 1960, p. 27. reported 667 long-term leases with aggregate minimum rentals of over $11 million per year.1 Types of Leases As with other forms of contracts, the lease can be "tailor-made" to meet the needs of the parties involved. For this reason, leases vary greatly with respect to term, duties of various parties, restrictions, alternatives at termination, method of payment, flexibility, and purpose. With this wide array of provisions many methods of classification are potentially available. One which seems particularly appropriate to this study is a method which has been suggested by Professor John H- Myers which classifies leases according to their fundamental purpose. Professor Myers has indicated that leases are generally of two types.2 The first of these may be designated as a service lease. It is entered into solely for the services to be rendered, these services being pro- vided by the lessor over the term of the agreement. The other major type of lease has financing as its fundamental objective and for this reason may be designated as a financial lease. Under the financial lease, the lessor provides all of the service which is required of him at the beginning of the contract. From then on he simply sits back and collects the rent while the lessee is given "quiet enjoyment" of the property. The lessor is not called upon to render service over the period of the agreement. An example of this type of 1Montgomery Ward and Company, Inc. , Annual Report, February 1, 1961, p.11. ZAn address given by Professor John H. Myers at the technical session "Progress in Accounting Research" at the 74th Annual Meeting of the American Institute of Certified Public Accountants, Monday, October 30, 1961, at McCormick Place, Chicago. contract is a typical sale-anduleasewback agreement. Under both types of lease, the lessee customarily utilizes the service over the entire life of the agreement. The distinction between the two cannot be made on the basis of when the lessee receives the benefits from the contract; rather it must be made on the basis of when the lessor fulfills his part of the agreement. Where the lessor is called upon to render this service throughout the duration of the lease, the arrangement may be termed a service lease. On the other hand, when the lessor is called upon to provide funds and perform other duties at the beginning of the lease and where the contract is essentially "performed" from the standpoint of the lessor, the agreement is termed a financial lease. Many leases are probably neither wholly financial nor entirely service leases but rather are hybrids instead. Professor Myers has suggested that the rentals payable under each such lease be separated into service and finance components. He has noted that this task would be no more complex than other joint cost problems currently faced by ' the accountant and has suggested five possible criteria for making the separation: 1. Does the agreement use up part of the firm's "pool" of credit? 2. Who bears the rewards and risks of ownership? 3. Was the decision to lease based upon financial or operational considerations ? 4. Does the lessor rely primarily upon the general credit of the lessee? 5. Is it customary to lease this type of property?1 It is not within the scope of this study to determine whether or not all leases can be properly divided into their financial and service com- ponents. It will be assumed here that such a distinction is possible. 1Myers address, 22. gi_t_. 10 To the extent that this assumption is not valid, the application of the findings contained herein will be limited. The service lease presents no serious accounting problems. Under this type of contract, the rentals are recorded only to the extent that they are paid or accrued. The lessee has no asset under this type of agreement except insofar as the rents are prepaid. Nor does he have any liability except to the extent that services have been received but have not yet been paid for. An example of such a contract is the lease of telephone service. The financial lease, on the other hand, presents some very serious accounting problems to which the remainder of this study will be devoted. The Financial Lease In order to gain a better understanding of the nature of the prob- lems, it is necessary to examine the financial lease more closely. Some of its more common characteristics are as follows: (1) The decision to lease is based primarily on financial con- siderations rather than on strictly Operational reasons: i. e. , leasing is considered as a source of capital by management. This method is selected after giving consideration to other forms of financing such as issuing capital stock, retention of earnings, or borrowing through bank term loans or mortgage bonds. (2) The lease is normally noncancellable, or is cancellable only under heavy penalty, during the initial term of the lease. (3) The rentals payable under the lease agreement are designed so as to return to the lessor the total cost of the asset involved plus a return on the invested funds during the initial term of the lease.1 ¥ 1In many financial leases the rentals are not fixed but are based upon a certain percentage of the gross sales or profits of the lessee from the property. Such leases are usually termed "percentage" leases and ll (4) The lessor-mthe legal owner of the asset-wretains title to the property involved at the expiration of the initial lease term. However, provision is often made for the lessee to obtain use of the property after this date by the lessor granting to the lessee either an option to renew the lease at reduced rates or an option to buy the property.1 In either case, the lessee must, make additional payments (above and beyond the asset cost plus a reasonable return thereon) in order to have continued use of the property. normally provide for a fixed minimum rental which is required to be paid regardless of the level of sales or profits. In these cases the guaranteed or minimum rentals are designed so as to return to the lessor the total cost of the asset involved plus a fixed return on the invested funds. The "premium" rentals resulting from the percentage clause would represent additional return to the lessor, above and beyond his in- vestment. 1There is some danger of losing certain tax advantages by includ- ing a purchase option in the lease agreement. However, it appears that the purchase option will generally not jeopardize the deductibility of the rental payments provided the purchase price reasonably approximates the fair market value of the property at the date of purchase. Prentice- Hall sets forth the following guides for distinguishing a lease from a sale for tax purposes: "No general rule can be given, and each case must be decided on its own facts. However, generally, in the absence of evidence of a true rental, agreements for the lease of property will be treated as purchases and sales if one or more of the follow- ing conditions are present: (1) Portions of periodic payments apply specifically to an equity to be acquired by the "lessee". (2) "Lessee" will acquire title on payment of a stated amount of "rent" which must be paid in any event. (3) Total amount that "lessee" must pay for a relatively short period of use is very large compared with the amount needed to get transfer of title. (4) Periodic payments materially exceed current fair rental value. (5) Property may be purchased under an option at a price which is (a) nominal in relation to value of property at time option 12 (5) Financial leases often contain what is usually termed a "rejectable offer" clause. Under this provision the lessee may offer to purchase the leased asset at any time according to a schedule of pre-= determined prices. If the lessor rejects the offer of the lessee, the agreement is automatically canceled. (6) Financial leases normally employ the ”net lease" principle which requires the lessee to pay all maintenance costs, repairs, insur- ance, taxes, alterations, and all other costs (other than initial costs) normally associated with ownership. The purpose of this clause is to make the rental payments clear or "net“ to the lessor so that the return he receives during the initial term of the lease is certain and determin- able in advance. (7) The primary security behind a financial lease is normally the general credit of the lessee rather than the value of the leased property. The following statement of policy by one of the nation's largest insurance companies indicates the importance of the general credit standing of the lessee in such transactions: may be exercised, or (b) relatively small compared with total required payments. (6) Part of the "rent" is specifically designated interest, or is easily recognizable as the equivalent of interest. (7) Total rental payments plus option price approximate price at which property could have been purchased plus interest and carrying charges. " l [Numbered inserts are mine.] 1William F. Connelly, Robert B. Mitchell, and Stanley B. Tunick (eds.), Prentice-Hall 1962 Federal Tax Course (student edition; Engle- wood Cliffs, N. J.: Prentice-Hall, Inc., 1961), p. 1837. For a dis- cussion of tax aspects of leasing see: David Schaff, "When Is a Lease a Sale for Tax Purposes?" The Controller, Vol. XXVII (February, 1959), pp. 70-72, and Frank K. Greiesinger, "Equipment Leases Can Schedule Payments, and Deductions, to Avoid Tax Hazards, " The Journal of Taxation, Vol. XIII (October, 1960), pp. 226-227. 13 The first factor to be taken into consideration is the credit of the proposed tenant. The tenant should be a larger, well- known corporation of some national prominance to whom we would be willing to lend money on their unsecured debentures. Such matters are referred to our bond department for analysis and their recommendations. 1 Financial leases are generally of two types. Under the first, the two-party lease, the company desiring to obtain the use of a particular asset (land, building or equipment) negotiates a lease directly with the owner. The latter party (the lessor) supplies the funds necessary to finance the transaction. The lessor may be either the manufacturer of the asset or a separate leasing company that has purchased the asset from the manufacturer for the purpose of negotiating the lease. The important fact is that the lessor assumes the financial burden. The second type of financial lease, and probably by far the most common form, is the three~party lease agreement. This varies from the two-party lease primarily in that the funds are not provided by the lessor but are furnished by an outside financial institution. In this case there are three parties to the lease: the lessor, who owns the asset; the lessee, who obtains the use of the asset for a specified period of time; and the financial institution, which furnishes the funds necessary to finance the transaction. As in the case of the two-party lease, it is the general credit of the lessee corporation that is the major security behind the lease. The importance of this point is stressed by the follow- ing statement made by an insurance company executive: In the field of direct placements insurance companies are from time to time offered investments in the long-term debt obligations of corporations which have been organized as part of the financing transaction (or adapted therefor) and derive their borrowing capacity from leases to or contracts with other lAs quoted by Albert H. Cohen, "The Future of Lease Financing under New Depreciation Rules, " The Journal of Accountancy, Vol. XCVIII, (August, 1954), p. 190. l4 corporations of established high credit standing. Although the borrower acquires valuable property as part of the financing transaction and is usually required to secure its obligation with a first mortgage on such property, the lender looks to the lease or contract with the high credit corporation as the princi~ pal security for its loan and relies upon the income provided to the bqrrower under the lease or contract for repayment of the loan. In a study of equipment manufacturers, Alvin J. Bytwork found a similar stress on the credit of lessee companies where the lease being negotiated was primarily of a financial nature. In a questionnaire which was sent to selected companies he asked: ”If a customer's credit position was too poor for a financed sale, would you normally give him a: rental? rental purchase? finance lease-recommendation?“ In response to this question Bytwork found that while over half of the reSpondents would flequipment to a firm with a weak financial position, less than three per cent would enter into a financial lease arrangement with the same firm.3 This rememphasizes the importance of a high credit standing as a prerequisite to a financial lease. While there may be many legal differences between the two-party and the three-party lease, financially speaking, they are the same. Both lean heavily on the general credit of the lessee corporation. Advantages and Disadvantages of Leasing There has been a great deal written both for and against leasing. While it is not the purpose of this study to evaluate the desirability of 1Ralph L. Gustin, Jr. , "Financing by Contract and by Lease-- Some Considerations, " paper read before the Association of Life Insurance Counsel at The Plaza, New York, Tuesday, December 10, 1957. 2Alvin Jay Bytwork, "The Effectiveness of Alternatives to Purchase in the Marketing of Construction Equipment Through Distributors, " un- published Ph. D. dissertation, Department of Marketing and Transporta- tion Administration, Michigan State University, 1961, p. 126. 31bid. 15 leasing, it is nevertheless essential that we examine some of these arguments in order to determine the true nature of the transaction for which we are accounting. Many of the advantages of leasing are rather artificial and do not hold up after careful examination. They seem to be attempts to make leasing appear to be something that it is not-- a cure-all for financial difficulties or a readily available substitute for financing. They tend to obscure the fact that leasing is a means of financing--nothing more or less.1 For purposes of discussion, the advantages of leasing may be classified into five groups as follows: first, advantages which are over- stressed; second, advantages of avoiding ownership; third, advantages in laws and regulations; fourth, advantages of financial leverage; and fifth, advantages of improved financial position. Advantages Which are Over-Stressed 1. Leasing provides greater flexibility than does ownership in the event that the asset becomes unprofitable. 2. Leasing is an economical method of obtaining expert servic- ing of equipment beyond the capability of the firm's own maintenance department. 3. Leasing permits cost savings. 4. Leasing presents special accounting advantages to a firm using direct costing. lSince leasing is only a means of financing, the decision to borrow or lease should be based largely upon quantitative differences. For a discussion of various methods of quantifying financing alternatives see: William D. McEachron, "Leasing: A Discounted Cash-Flow Approach, " The Controller, Vol. XXIX (May, 1961), pp. 213-219; Edward A. Ravens- croft, "Return on Investment: Fit the Method to Your Need, " Harvard Business Review, Vol. XXXVIII (March-April, 1960), pp. 97-109; ThOmas N. Spaeth, "Discounting Differential Cost in Machine Replace- ment--An Outline, " N.A.A. Bulletin, Vol. XLI (June, 1960), pp. 18-20; Allen Sykes, "Lease or Buy-~An Exercise in Economicu-Accounting Arithmetic,"Accountancy, Vol. LXXI (March, 1960), pp. 153-156; Richard F. Vancil,. "Lease or Borrow--New Method of Analysis, " 16 The above arguments seem to be perfectly valid under certain circumstances but are often overwstressed in importance or else preu sented as though they had almost universal application. An example is the argument that leasing provides increased flexibility. It is true that under certain circumstances the lease may increase a firm's flexi- bility; however, there is nothing flexible about a long-term noncancell- able lease agreement which provides the firm almost no escape if the asset should prove unusable. On the other hand, if the firm owns an asset rather than leases it, and the property becomes unprofitable, it can sell the asset thereby providing more flexibility than under a lease agreement. Advantages of Avoiding Ownership 1. Leasing eliminates the need for preparation of time-"consuming depreciation schedules and subsidiary fixed asset schedules. 2. Leasing enables a firm to gain the use of assets without the problems associated with ownership. The above arguments are not valid because they merely represent "shifted headaches. " It is true that by leasing, the user of an asset can avoid doing certain costly and time—consuming things, such as prepar- ing depreciation schedules and subsidiary records of fixed assets. He cannot, however, avoid paying for these activities because under a lease agreement the user of the asset merely "subcontracts" these functions to the lessor. It is not an advantage to be able to pay some outsider to do something that can be done more economically by your own staff. Harvard Business Review, Vol XXXIX (September-October, 1961), pp. 122-136; Richard F. Vancil, "Lease or Borrow--Steps in Negotiation, " Harvard Business Review, Vol. XXXIX (November-December, 1961), pp. 138-159. 17 Advantages in Laws and Regulations 1. Leasing enables the management of a lessee firm to avoid the "red tape" associated With capital expenditure controls. 2. Leasing enables a firm or division within a firm to stay with» in its operation budget. 3. Leasing enables firms to obtain certain federal, state, and local tax advantages. 4. Lease charges are reimbursable costs under certain Govern» ment contracts whereas the cost of financing (debt or equity) is not. 5. Leasing avoids the restrictions which normally accompany long-term debt. This group of arguments represents leasing "loopholes. " They are valid arguments in favor of leasing only because some responsible party has failed to understand the true nature of the financial lease. For example, in many companies top management has established capital expenditure controls with the idea that all major acquisitions of property must be properly justified. Because these managements have not under: stood the true nature of the financial lease, the control procedures have only been extended to ”purchases" of property. As a result of this "loophole, " lower management has by—passed these controls by acquiring the desired equipment through longs-term lease agreements, often at considerably higher cost. Similarly, the misunderstanding of the true nature of the financial lease has resulted in the enactment of poor laws and regulations. For example, the Armed Services Procurement Regulations clearly exclude the cost of borrowed funds as a reimbursable contract cost. On the other hand, in regard to leases, the regulations state that "rental costs of land, building and equipment and other personal property are allowable if the rates are reasonable. "1 1Armed Services Procurement Regulations 15-~205. 34 (a). 18 Certainly this is an advantage of leasing from the standpoint of the contractor and has probably contributed to its Wide use in defense industries. However, there is no- sound reason why the interest factor contained in a lease agreement should not be treated as a cost of debt. The provision in the Armed Services Procurement Regulations which allows the interest element in a lease payment as a reimbursable contract cost while excluding the cost of "debt" is simply a tax "loophole. " It seems likely that the officials who prepared the regulations were not aware that the wording would permit contractors to shift the cost of capital to the Government. Some state and local laws are similarly deficient. For example, where tax levies are based upon the firm‘s total capital rather than upon its equity capital only, the leased assets are often exempt from the tax. One such act, the Texas Corporate Francise Tax, states: The tax is based upon that proportion of the stated capital, surplus and undivided profits, plus the amount of outstanding bonds, notes and debentures (outstanding bonds, notes and debentures shall include all written evidences of indebtedness which bear a maturity date of one year or more from date of issue. . . ), as the gross receipts from its business done in Texas bear to the total gross receipts from its entire business.1 In regard to this and similar laws Alvin Zises makes the following statement: Because law follows the mores and customs of a people, treatment of the leases as debt may eventually cause the taxing authorities to similarly treat all leases as debt. . . . In view of the clamor for taxes, the imagination need not be stretched to foresee how the state of Texas may View the capitalization of long-term commitments if they were reported as "evidences of indebtedness. " 7‘ lCommerce Clearing House, Topical Law Reports, State Tax Guide (2d ed.; Chicago: Commerce Clearing House, Inc., 1961), p. 856. ZAlvin Zises, “Disclosure of Long-Term Lease, " The Journal of Accountancy, Vol. CXI (February, 1961), p. 40. l9 Zises' point is a valid one from the standpoint of lessees, lessors, Government contractors, or others who may have vested interests in current tax "loopholes. " From the standpoint of the taxpayers who are carrying an unfair share of the tax load, however, the picture is quite different. Advantiges of Financial Leverage 1. Leasing frees working capital and gets the merchandising or manufacturing company "out of the real estate business. " 2. Leasing enables a firm to acquire modern equipment that it could not otherwise afford. 3. Leasing avoids dilution of ownership. 4. Leasing provides a hedge against obsolescence and inflation. The above arguments are really not advantages of leasing only but advantages of _r_1_o_t_ using equity financing. They are equally applic- able to conventional debt, leasing or any other form of non-equity financing. They are really arguments in favor of using financial leverage or of "trading on the equity. " This theory states that if a firm can earn more on an investment than the cost of the funds invested, the excess amount will represent a "windfall" gain to the stockholders. , It makes no difference whether the funds are provided through a lease agreement or through more conventional debt instruments. The principle is still the same. In comparing any form of debt to equity, the arguments pre- sented in this group seem to be perfectly valid.1 In comparing the 1The theory of "trading on the equity" has long been accepted as a fundamental principle of finance. However, recently Modigliani and Miller have challenged the advantages to the company's residual owners of favorable "trading on the equity. " For an excellent discussion of this subject see: F. Modigliani and M. H. Miller, "The Cost of Capital, Corporation Finance, and The Theory of Investment, " The American Economic Review, Vol. XLVIII (June, 1958), pp. 261-296; D. Durand, "The Cost of Capital, Corporation Finance, and The Theory of Invest- ment: Comment, " The American Economic Review, Vol. XLIX (Septem- ber, 1959), pp. 639-654; and F. Modigliani and M. H. Miller, 20 lease with the more conventional forms of debt financing, however, these arguments are of no concern. Any case presented in favor of leasing should make the fact clear that these particular advantages are not unique to leasing but are equally applicable to conventional debt financm ing. The buy-lease controversy would be much more clear if it were not cluttered with arguments which are not applicable. Advantages of Improved Financial Position 1. Leasing improves the lessee company's balance sheet. 2. Leasing improves the lessee company's financial ratios. 3. Leasing increases the total amount of credit which is available to a firm. 4. Leasing provides one hundred per cent financing rather than sixty-six and two-thirds per cent or seventymfive per cent. 5. Leasing permits greater turnover of capital. The above arguments are all associated with the method of balance sheet presentation and are heavily stressed in promotional literature of the leasing industry. Typical of this literature are the following com- ments taken from-a promotional pamphlet of United States Leasing Corporation: For the very simple reason that a lease is not a loan, your credit is effectively conserved when equipment-is—I-e-ased. . If funds are borrowed for the purchase of equipment, existing lines of credit will be reduced by a like amount. If the equipment is leased, on the other hand, credit lines remain virtually intact since the lease is financed through United States Leasing Corporation. In effect, therefore, leasing extends your present borrowing ceiling, because: The combination 2? leasing and borrowing--compared t9 borrowing alone--produces the greater command of credit. Since leasing "The Cost of Capital, Corporation Finance, and the Theory of Investment: Reply, " The American Economic Review, Vol. XLIX (September, 1959), pp. 655-669. 21 permits the acquisition of equipment without disruption of exist-a ing credit lines, it serves as a new and practical credit source. The balance sheet effect of leasing can also be important. If equipment is purchased and capitalized, it follows that liabilities will be increased, the assetwto-liability ratio will be impaired and liquidity will be decreased. When the equipment is leased, on the other hand, your important ratios remain unchanged. The net re- sult is a cleaner balance sheet, with neither impairment of credit nor reduction of liquidity. For balance sheet purposes, the net effect of leasing is clearly shown by the following comparison between cash purchase, conventional borrowing, and leasing. The comparison is based on the acquisition of equipment having a total cost of $25, 000. If Equipment Before After costs $25, 000 Obtaining Buying After After Equipment for Cash Borrowing Leasing Current Assets $100,000 $ 75,000 $100,000“ $100,000 Fixed Assets 50,000 75,000 75,000 50,000 Total $150,000 $150,000 $175,000 $150,000 Liabilities $ 50,000 $ 50, 000 $ 75, 000 $ 50,000 Capital 100,000 100, 000 100, 000 100,000 Total $150,000 $150,000 $175,000 $150,000 Liquidity (Current Ratio) 2 to l 1. 5 to 1 l. 33 to l 2 to 1 Debt of Equity 1 to 2 l to 2 1. 5 to 2 l to 2 "But the required compensating balance is frozen and cannot be used.1 Although the above financial statements seem to present a strong case for leasing, there are instances where it would be desirable for the lessee to include the leased property in his balance sheet. One writer 1United States Leasing Corporation, The Engineered Equipment Lease. A promotional pamphlet of the United States Leasing Corporation, c0pyright 1961. 22 has gone so far as to suggest that the accountant. prepare two balance sheets and that the lessee use whichever is to his advantage in the particular circumstances. (Talk about wanting to have your cake and eat it too'.) He writes: The overall operating strength of a company . . . which leases will be apparent to anyone who studies its operating reports. Furthermore, the balance sheet of the lessee corporation will not depict a large outstanding liability in the form of conditional sales accounts payable. When the use of chattel assets is acquired on leasing programs the lease liability is not shown on the balance sheet as a liability. Of course there is no asset account for the leased equipment on the asset side; however, the asset to liability ratio and income to liability ratio will be higher. These ratios are important to creditors and to shareholders. Thus a lessee may, by leasing, save its regular credit sources for other pur- poses, and at the same time show a favorable balance sheet and current operating report when the time comes to utilize this credit. The advent of extensive balance sheet footnoting may result in the listing in footnotes of the leasing contracts, but accountants are by no means agreed as to the necessity for this practice. Even if the listing is necessary, the strength of this operating position will still be apparent. Conversely, there may be an economic advantage in leasing for some public service corporations, such as utilities, airlines, and the railroads, which has not been utilized because of this standard balance sheet presentation. Should not the airlines in- clude those leased assets which they use in their business when figuring their rate base, even though these assets are not listed on the balance sheet? Accountants recognize that the presentation of the economic picture of a corporation can take many forms, and may require different techniques or sets of reports for different problems. These different reports need not coincide as long as they truly depict the accounting information which it is their func- tion to impart. Business enterprises should be able to include their leased assets on their balance sheets for rate making purposes, even though for certain other general accounting purposes these assets are not to be so listed. This concept is realistic and feasible. It should be remembered that in many cases the lessees' control of their leased equipment is virtually complete under the lease terms. The rental payments often purchase the use of the equipment 23 for its entire useful life. If the rate determining agencies must cling to ownership concepts in determining these rate questions, this control of equipment is sufficiently akin to ownership to be reflected in the rate base. This legal and accounting treatment of leased equipment could be fairly applied to many situations. The airlines, for example might lease their entire ground equip- ment fleet, and still retain the benefits of using these assets in their rate determination proceedings.l The weakness in this last group is the fact that the arguments are all based upon incomplete information presented in the financial state- ments. To the extent that the readers of these financial statements fail to look beyond the information presented in the body thereof, these are valid advantages from the standpoint of the lessee. They represent balance sheet "illusions" because the statements upon which they are based do not present all the financial facts. The methods of balance sheet presentation will be discussed at length in subsequent chapters. Suffice to say here, any acceptable method must present a complete report of the financial facts associated with the transaction. . It should not tend to give one form of financing a competitive advantage over another. Selection of a method of financing is a decision that should be made independently of the accounting and reporting treatment. General Misunderstanding The stressing of "half truths " in advertising is not peculiar to the leasing industry. . In fact the proponents of leasing have properly noted that banks do not tell the whole truth when they quote a five per cent interest rate on term loans which require a compensating balance.z 1Charles W. Steadman, "Chattel Leasing--A Vehicle for Capital Expansion, " The Business Lawyer, Vol. XIV (January, 1959), pp.. 525-526. 2See for example: Clyde William Phelps, "Small Business and Motor Vehicle Leasing, " Credit and Financial Management, Vol. LXI (May, 1959), p. 21. 24 This practice of "fudging" has long been a part of American business and will probably continue toplay a part in business decisions. The thing that is most disturbing about the arguments presented in favor of leasing is the fact that outsiders, supposedly acting in independent roles, have likewise been guilty of presenting a slanted case for leasing. "The Pros and Cons of Leasing, ” a study published by The Foundation for Management Research, is a case in point. This study is directed to smaller manufacturers, department stores and supermarkets and presents several case studies which seem to make leasing appear to be much more attractive than other financing alternatives. The case studies presented are based upon some very important assumptions which are not clearly stated. Not withstanding the special nature of these cases and in spite of the important assumptions made, the Founda- tion makes the following statement: While the dollar cost of leasing is greater than purchase through cash, the net cost is less. Actually, the net cost of leasing is less than—(rash purchase, less than purchase through conditional-sales contract, less than—a—ny other means of acquir- ing the use of the equipment.1 In order to see what is behind this statement, let us refer to the illustrations upon which it was based. The case studies were prepared based upon the following set of facts: Using the lease payment schedules typical for small and medium-size enterprises, we might look at a typical company considering leasing, and see what its choices are. The company, a medium-sized manufacturer, called the Widget Corporation, has a net worth of $250, 000 and liquid working capital of $100, 000. Net profits (after taxes) on net working capital of the company is assumed to be a typical 14 per cent, the corporate tax rate is 52 per cent, and profit before taxes 1The Foundation for Management Research, "The Pros and Cons of Leasing: A Study for Smaller Manufacturers, Department Stores, Supermarkets, " (Chicago, Illinois: The Foundation for Management Research, c.1960), p. 9. 25 on net working capital is about 30 per cent. This manufacturer wishes to acquire some new machinery, costing $25, 000 with a composite life of ten years and no scrap value. (These assump- tions are made in round figures for ease of computation. In reality, the life of the equipment may be longer or shorter, and the equipment may have some or no cash value at the end. These variables do not materially affect the statistical conclusions below.) Such a manufacturer in wishing to use this equipment, has four choices: (1) he can buy it entirely for cash taken out of his liquid capital; (2) he can finance it through a conditional sales contract; (3) he can finance it through his bank and repay it in instalments over (say) three years; or (4) he can lease the equip- ment.1 Case studies were prepared to compare the four alternatives which faced the Widget Corporation. These are reproduced in Exhibits 1 through 6. Each study indicates that although the gross dollar outlay of leasing is greater than under any alternative, the net cost of leasing is less. The conclusions may be summarized as follows: Cash Purchase vs. Leasing: 1. In the 10th year of leasing, the company's working capital is still greater by $5, 469 (as shown in column 3 of Exhibit 2) than it would have been under the cash purchase plan. 2. Company net profits after taxes for the 10-year leasing period, are greater by $12, 436 (as shown in column 7 of Exhibit 2) than under the cash purchase plan. Conditional Sales Contract vs. Leasing: 1. In the 10th year, as a result of leasing, the company's working capital is still greater by $1, 944 (as shown in column 3 of Exhibit 4) than under the conditional sales contract purchase plan. 2. In the 10th year, as a result of leasing, the company's net profits after taxes for the lO-year period are greater by lIbid. 26 $6, 844 (as shown in column 7 of Exhibit 4) than under the sales contract purchase plan. Bank Loan vs. Leasing: l. The calculations in Exhibits 5 and 6 show clearly that a company leasing $25, 000 worth of equipment, after 10 years would still have $1, 337 more working capital on hand (as shown in column 3 of Exhibit 6) than the company would have had if it borrowed the cash from a bank on a three—year instalment basis, and used the cash to buy the equipment. 2. Similarly, at the end of 10 years, a company leasing the equipment would have $6, 537 more net profit after taxes (as shown in column 7 of Exhibit 6) than if the same company had bought the equipment for cash, using a bank instalment loan for the funds.1 A closer analysis of the exhibits presented by The Foundation for Management Research reveals quite a different picture. To begin with, the conclusions presented by The Foundation ignore the fact that in all cases the gross outlay is greater under leasing than under any other alternative. For example, the gross outlay is actually $12, 874 greater before taxes and $6, 175 greater after taxes under leasing than under the cash purchase. This means that the company's net profits after taxes for the ten-year leasing period are greater by only $6, 261 rather than $12, 436 as stated by the Foundation; i. e. , what the Foundation states is the "net profits after taxes" is really extra mincome from leasing. The "net profits" can be computed only after deducting there- from the extra expenses of leasing. By combining the figures shown in Exhibits 1 and 2 we arrive at this same conclusion; i. e. , the net ' advantage of leasing is only $6, 261, the difference between the $6, 175 in column (k) of Exhibit 1 and the $12, 436 in column (7) of Exhibit 2. lIbid. , pp. 10-11. Table numbers are mine. 27 630.300.. 05.53.. 0.5 .o 05.2.00 .050 :< £00008... 0000.0..0002 00. 00:00:00... 05 .0 0060.508. 8.. 5.3 :wEmeeu. .0 0:00 0:0 00.... 0:9... 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Rand 2: SJ .8 .33 88.3 S WVF..V VKN 00“ L .‘ x. p..w.— ANA—R"; O .56 in new a \ in.“ 88.9 m .33 SJ. «8 Jsc J 25.. 83.: u 33 :0 Re 5.». _ £3. .3: 0 ..EJ. oR v2 J 5an 2%.. n .36 :0 woo; 7.0 — mend wand v v.3.“ J50.— nm... 9:8 83 8.3.. n 02.. 30 2o.— .J..;.. End 0K6 u n,J.._:m » 3m » n; m of: w 03.3 03.... w J 3.3. ..ozo 3x0. 3:0 30.0... “.30... T .J .333 3:..qu .00» 2.. $500 mmcmEom v ..oU n ..ou :0 {can J. _.. 35.5.3 too; 03738.5 .0 o\omn .0 .0 nmfisom J. . M #51200 3x0... 0E8:— 3: .5}; SE _rJz.u s... .68“. E .2 5 E E E E :00.— xcom o\o mm £3, umBnEoU m0 @530.— >n v02". _ozaou :0 3555 1300?... 0 ha :53 33 Applying the same reasoning to the other case studies, we find that the net profits after taxes for the tenayear period are greater by only $2, 224, rather than $6, 844 under the conditional sales contract purchase plan ($6, 844 in column (7) of Exhibit 4, less the $4, 620 in, column (k) of Exhibit 3). Similarly, the company leasing the equipment would have only $1, 529, rather than $6, 537, more net profit after taxes than it would have had if it borrowed the cash from a bank on a three-year instalment basis, and used the cash to buy the equipment ($6, 537 in column (7) of Exhibit 6 less the $5, 008 in column (k) of Exhibit 5). In the tables, as well as in the conclusions the Foundation made the assumption that the equipment would have no scrap value at the end of the ten—year period. They later discuss the impact that a ten per cent salvage value would have on the conclusions reached. Since the sale of the asset at the end of the tenth year would be subject to capital gains tax, the after-tax gain on the sale of the equipment would amount to $1, 875 (seventy-five per cent of $2, 500). This would represent an additional advantage of ownership which would reduce the savings from leasing to only $4, 386 under the cash purchase plan, to a mere $349 under the conditional sales contract, and actually reverse the bank loan case so that it favors ownership by $346. The most serious objections to the study published by The Founda- tion for Management Research relate to the underlying assumptions. To begin with, the assumption was made that the thirty per cent relationship between profits before taxes and net working capital would hold true in the future regardless of the relative proportions of fixed assets and working capital. This implies a relationship which is absurd. A company does not earn profits on net working capital alone, but on all assets. The primary difference between current assets and fixed assets is one of time, and it is ridiculous to imply that only current assets 34 contribute to a firm's earnings. If profits were in fact earned only on current assets, then it would pay a firm to sell all non-current assets and put the cash to "work. " And then, why stop there? Any firm that can earn thirty per cent return on any cash they can obtain should place no limit on borrowing. In fact, it would be profitable for them to pay as much as twenty or twentwaive per cent interest, since they would still come out ahead. Another assumption which was passed over very lightly was the period over which the loan was to be repaid. Since the entire case for leasing was based on the "cash flows, ” the period of repayment is a key factor. The assumption that the loan is to be repaid "in instalments over (fl) three years, " is a necessary condition for making the lease appear more attractive. This may be illustrated by referring to Exhibits 7 and 8 in which all assumptions are the same as those made by the Foundation for Management Research in Exhibits 5 and 6 except that the bank loan is assumed to be payable in ten equal annual instal- ments instead of requiring a fiftyI per cent payment during the first year and a twenty-five per cent payment during each of the next two years. By making only this one simple change in the assumptions, the outcome is completely reversed. Instead of favoring leasing by $1, 529 after taxes (Exhibit 5 and 6), the case now favors ownership with bank financing by $19, 803 ($181 from column (k) of Exhibit 7 and $19, 622 from column (7) of Exhibit 8). Again, note that this complete reversal in conclusions came about solely by changing the period over which the, loan was to be repaid. 1 This is hardly a point to be passed over lightly, and yet the terms of loan repayment were scarcely mentioned by the Foundation for Management Research in their "non-partisan" study. 1Even the Foundation's assumption that the interest rate was five per cent on the original balance was retained, although it probably would have been more reasonable to assume that the interest was computed on the declining balance. If this one additional assumption is introduced, the case would favor ownership with bank financing by $24, 482 instead of by the $19, 803 indicated above. find?» 025 thus ma» mo gomo mcwnsp psoacnom acoo pom m>¢l$co2$ m was no?» umufl 93 waist unmetnmm ”Emu pom ~33“ .m 93.3.9on mo powwow: mucogfimumcfi Hodccm fiasco Coo. a: osmtwmm on. o» @0326 mm ma Good xsmo. mg» was» “among m “BHUTAN a: poms mmoau mm $0,303 353 SM madam 93 who mmcmmeA c5300 pad mcowaadmmm 3.4 an" 35 Hoo.-~w ooo.mmm oo¢.o¢~m ooo.m~a oom.NHm Asmsv Hoo.-m ems.sm oom.~ ¢HH.mN Mme omN.s ooo.om mem.00m oh Amww.mv mew.oom Nam.s~ oom.~ mem.¢~ poo om~.s ooo.om mow.oeN o Amev.vv moe.okm ooo.sm oom.~ Hes.¢~ mom.s omm.s ooo.om www.em~ w Awom.sv www.km~ mew.sm oom.~ mow.¢m wsw.s omm.s ooo.om omo.omm a Aosw.kv omo.omm mm0.- oom.~ ash.vm mnm.~ omm.s ooo.om omo.mHN o Aoms.ov smo.mH~ mam.~N oom.~ Nmo.mm FNF.N omN.H ooo.om mms.aah m Awsm.oav wmo.aos mmm.- oom.m moo.m~ NwH.M omm.s ooo.om mwo.oos w Amoo.ssv mwo.aos No».mm oom.~ wm¢.m~ wmo.m omm.s ooo.om H¢~.owa m Asso.ev Hom.ovh mmo.mm oom.~ NNN.MN moo.¢ omm.s ooo.om mom.mms N Ammo.mva mom.mmsw mo~.mma oom.~m nwo.-m msm.ew omm.sa ooo.oma ooo.oosm a ”mmGJUHDnH ovo.ammm Has.o¢~m o¢~.wmm oss.amm ooe.m~ omm.mm om~.s ooo.om ov~.wo~ on ow~.wo~ oov.mm omm.mm omm.n ooo.om ovw.ve~ o owm.wk~ oov.mw omm.mm omm.s ooo.om o¢¢.smm w owv.smm oov.mw omm.mm om~.s ooo.om ovo.m- a oeo.wm~ oov.mm omm.m~ omm.s ooo.om ovo.¢o~ @ oso.eom oov.mm omm.m~ omN.H ooo.om owm.sws m oem.sws ooe.mm omm.mm omN.H ooo.om o¢m.ems v oww.nma ow~.os www.0N mmw.o ooo.om oom.me m oom.wm2 owm.oa eww.om mmw.o ooo.om owm.osa N owm.ossm ow~.msw www.0Nm mmw.mw ooo.omw ooo.oosm a magnum ommod xxv A3 Ahv Amy CV Amv Any Auv Any Adv vw acmamfidflom wcwufidvoafl cw Good Madam £33 swam mowed mo COmCMQEOU h ,HHQHEXH 36 NNo.os Nov.N ooe.N Nos.m osm.ea ANA oh oNH.eH ¢o¢.N oso.N mms.m oss.es mvv.N a mos.¢a ooN.N oao.N oso.m oN>.oH mnv.¢ w omN.Ns ANN.N st.N kmw.¢ own.os «0N.o a mNo.m NNN.N ON¢.N Nmo.¢ Ham.ms mam.» 0 N88.» NHH.N moN.N Nav.s ose.ws end.» m eem.m Nmo.s Nms.N Hwa.v Now.ms mHN.oH N swm.m sew.s moo.s N¢N.N mow.Ns moo.aa N N¢>.s pea.s okN.H Nm¢.N oes.w Has.e N mom a mom a Nae a >~H.H$ NN¢.N m NNo.N m H mound... you? moxmu swam 2.309. 330R. Ab c5303 @83quan ammo». mmgcfimm mwgspmm v GEBOU m c8300 no?» 35.30pm >3 poouh m>flmfisgso mo mmmm. am so maom Hm Scum mmcmsumo Hmfinmmu moxmu oEousH mmawcumm vim—MHDESU 93m Hmfimmu dough “so Asa Amy Ave Amy ANS adv wcfimmod no?» woummEoU wcflocmcwh Mcmm £33 QEmHQCBO >3 pomnh Hmfiamo co mmadzmm poaoohoum w HHmHEXM 37 A third objection to the study by the Foundation for Management Research is the fact that no mention was made of the interest rate implied in the lease agreement. The case studies state that the "finance rate" is "six per cent per year of the original cost of the equipment. Renewal rate: five per cent per year. " Although they are likely to be confused with interest rates, the six per cent and the five per cent quoted above are actually rental rates, not interest rates. The "true" interest rate implied in the lease, assuming the equipment has no salvage value, is 16.1 per cent'. The fact that the cases presented by The Foundation for Manage- ment Research deal with only one isolated transaction is another reason the cases are "tilted" in favor of leasing. The assumption is apparently made that once the decision regarding this particular piece of equipment is made, the Widget Corporation's capital budgeting problems will be solved for the next ten years. Or, should the company find that they need another new piece of equipment the second year, they would pre- sumably evaluate the "buy-lease" alternatives and again conclude that leasing would be most profitable. The truth of the matter is, however, that capital budgeting cannot be done effectively on a piece-meal basis. To be effective, a firm must forecast its capital needs for several years in advance and simultaneously plan for financing. To illustrate the danger of looking at isolated transactions, let us assume that the Widget Corporation decides to lease the asset in question based upon the careful analysis suggested by The Foundation for Management Research. Assume further that as existing assets wear out or become obsolete, the company finds it necessary to acquire additional equipment in subsequent years. Based upon the suggested analysis of each isolated transaction, the company selects lease financing in each case. This practice continues for a number of years until the 38 company finds itself "out of the real estate business"--all of its assets being leased. If the company were confronted with a $25, 000 capital budget each year, then ownership with bank financing would save the company $2, 880 per year after taxes. If the "freed capital" were put to work earning thirty per cent (as assumed in the other cases), then the com- pany would be better off to the extent of $36, 053 at the end of a ten-year period by owning rather than leasing.l The "illusions" and "100pholes" discussed in the preceding para- graphs make two points apparent. First of all, many of the listed advantages of leasing are not real and are based on faulty reasoning. As the true nature of the financial lease becomes more widely under- stood, we can expect these advantages to disappear. The second point relates to the responsibility for these ”illusions" and "loopholes. " To the extent that certified public accountants have contributed thereto, the accounting profession must bear the responsi- bility for their existence. If the accountant does not take the initiative in changing practices which create false impressions in the minds of the public, he will fast lose his professional standing when the truth is out . 1As discussed previously, the assumption that freed working capital will continue to earn thirty per cent return is absurd. It has been used here solely to make the cases comparable to those presented by the Foundation for Management Research. CHAPTER III EXTENT AND NATURE OF CURRENT FINANCIAL STATEMENT REPORTING This chapter is concerned with the current methods of reporting long-term lease agreements in published financial statements. The extent and nature of current reporting will be discussed first. This will be followed by an examination of the current rules for reporting as they have been prescribed by the American Institute of Certified Public Accountants and the Securities and Exchange Commission. Next, the causes of apparent deficiencies in the recording and reporting of long- term leases will be discussed. Finally, the rationale from which current reporting practices have evolved will be examined. Nature of Current Reporting Each year the American Institute of Certified Public Accountants publishes a study of the annual reports to stockholders of 600 industrial companies under the title Accounting Trends and Techniques. One of the subjects analyzed is the disclosure of long-term leases by lessees. . Exhibit 9 summarized the nature of the leasehold information disclosed in the 1960 survey. Of the 600 companies included in the survey, 223 referred to, or implied, the existence of long—term leases. Slightly more than half of this group provided details in varying degrees concerning these agree- ments; about one-third mentioned the leases without disclosing details thereof; and nearly one-sixth indicated leases only by reference to leaseholds or leasehold improvements. It is difficult to estimate the extent 39 40 EXHIBIT 9 Disclosure of Longw Term Leases by Lessees Details Set Forth In: Letter to 1960 1951 Disclosures by lessees Footnotes Stockholder Total Total Annual rental amount 133 3 136 59 Aggregate rental amount 10 1 11 2 Lease expiration date 27 1 28 14 Number of leases 57 2 59 37 Renewal option 15 1 16 13 Sale-lease-back feature 19 3 22 3 Term of leases 85 2 87 12 Total 346 13 359 140 Number of companies Setting forth details of long term leases 117 61 Mentioning long—term leases but omitting details thereof 69 Indicating long-term leases (without mention thereof) by 139 reference to leaseholds or leasehold improvements 37 223 200 Neither referring to nor indicating long-term leases 377 400 Total 600 600 Source: American Institute of Certified Public Accountants, Accounting Trends and Techniques, (15th ed.; New York: American Institute of Certified Public Accountants, 1961). Reproduced by permission of the American Institute of Certified Public Accountants. 41 to which leasing was prevalent among the 377 companies that neither referred to nor implied the existence of long-term leases. Virtually all of the companies that mentioned long-term leases did so in footnotes to the financial statements. One company .(Mohasco Industries, Inc.) incorporated the pertinent amounts in its balance sheet. Two companies (Arden Farms Company and Fairbanks, Whitney and Company) included lease obligations figures in their balance sheets in memorandum form only. , The remaining companies reported their 1 The amount of detail leases in footnotes to the financial statements. contained in these footnotes varied greatly as seen from the following illustrations: J. C. Penney Company At January 31, 1961 the total minimum annual rentals pay- able under leases expiring after five years was approximately $11, 700, 000. Leases covering about 79% of this amount will expire on various dates during the next twenty years.7‘ Calumet and Hecla, Inc. The Company and its consolidated subsidiaries have leased certain plant and warehouse facilities under long-term leases expiring at various dates to 1982. Aggregate rentals under such leases approximate $6, 321, 000, of which $337, 276 is payable in 1961.3 1Some of the details for a few of these companies were reported in the letter to the stockholders which accompanied the financial statements as part of the company‘s annual report. 2J. C.PenneyCompany, Annual Report, January 31, 1961, p. 15. 3Calumet and Hecla, Inc. , Annual Report, December 31, 1960, p. 10. 42 The May Department Stores Company The Company had eighty-six leases in effect at January 31, 1961 having terms of more than three years after that date. These leases provide for present aggregate minimum annual rentals of approximately $10, 647, 000 (of which $3, 848, 000 is payable to The May Stores Shopping Centers, Inc. andr$2, 922, 000 is payable to The May Stores Realty Corporation), plus in certain instances real estate taxes (such amounts being included in taxes) and other expenses and, in respect of some of the leases, addi- tional amounts based upon percentages of sales.1 Pepsi- Cola Company The Company and its consolidated subsidiaries are lessees under 41 leases having unexpired terms of more than three years which expire at various dates to 1992. The present minimum aggregate annual rental under these leases is approximately $1,800,000.Z Falstaff Brewing Corporation The companies are committed under long-term leases for rentals aggregating $307, 000 per annum. At December 31, 1960, there were commitments aggregating approximately $6, 600, 000 for property additions.3 Canada Dry C orpo ration The Company occupies eleven plants (eight of which were formerly owned by it) under leases of land and buildings which provide for current aggregate annual rentals of $615, 371 and 1The May Department Stores Company, Annual Report, January 31, 1961, p. 17. zPepsi-Cola Company, Annual Report, December 31, 1960, p. 33. 3Falstaff Brewing Corporation, Annual Report, December 31, 1960, p. 15. 43 successive renewal options for varying periods commencing 1967-80 at substantially lesser aggregate annual rentals, the Company also paying taxes, insurance, maintenance and repairs under these leases. In addition the companies occupy other prem- ises under long-term leases at aggregate annual rentals of $308,080.1 Federated Department Stores, Inc. Long-term leases at January 28, 1961 comprised 116 leases with unexpired terms of more than three years and with aggregate minimum annual rentals of approximately $8, 507, 000. Most of these leases require the payment of real estate taxes (recorded as taxes) and other expenses.2 Dresse r Industries, Inc. Total commitment under a continuing mobile equipment lease was approximately $5, 000, 000 at October 31, 1960. Annual rental payments thereunder are approximately $2, 9C0, 000.3 Air Reduction Company, Incorporated At the same date [December 31, 1960] the Company was lessee under leases, ending more than three years after that date, having an aggregate annual rental of approximately $2, 150, 000.4 lCanada Dry Corporation, Annual Report, September 30, 1960, p. 17. zFederated Department Stores, Inc. , Annual Report, January 28, 1961, p. 18. 3Dresser Industries, Inc., Annual Report, October 31, 1960, p. 18. 4rAir Reduction Company, Incorporated, Annual Report, December 31, 1960, p. 24. 44 R. H. Macy and Co., Inc. At July 29, 1961, the Corporation held leases of more than three years, the rentals under which, for the year ending July 28, 1962, amount to $9, 174, 000 plus, in certain instances, real- estate and personal-property taxes, other expenses, and additional amounts based on percentages of sales. The leases provide for varying lease periods, including renewal privileges, to 2059. Taxes incurred under the leases are included with other taxes in the statement of earnings.1 Crown Z ellerbach Corpo ration Premises at various locations are leased under long-term agreements with expirations ranging from 1964 to 2000 and, in some instances, with renewal privileges at reduced annual rentals. Current annual rentals under these leases, exclusive of real property taxes and insurance, aggregate approximately $3, 000, 000; this in- cludes ten premises leased under sale-and-lease-back agreements with rentals aggregating $2, 375, 000.2 Burroughs Corporation The total minimum annual rentals payable by the Company and subsidiary companies under leases expiring after December 31, 1963, aggregate $1, 920, 000.3 Allied Stores Corporation At January 31, 1961 the Corporation and its consolidated subsidiaries were lessees under 206 leases having terms of more than three years from that date. The rentals under these leases for the year ending January 31, 1962 amount to a minimum of $14,195, 441 (of which $9, 131,486 is payable to Alstores Realty Corporation and subsidiaries), plus in most cases, real estate 1960, p. 16. 1R. H- Macy and Co., Inc., Annual Report, July 29, 1961, p. 13. ZCrown Zellerback Corporation, Annual Report, December 31, p. 23. 3Burroughs Corporation, Annual Report, December 31, 1960, 45 taxes and other expenses and, in certain instances, increased amounts based on percentage of sales. The aforementioned minimum annual rental grouped by lease expiration dates is as follows: $3, 042,431 prior to 1980; $2, 674, 734 in 1981-1985; $3, 058,116 in 1986-1990; $1,966,100 in 1991-2000; and $3,454, 060 in 2001..2059.1 The American Hardware Corporation The company is lessee under two leases expiring in 1973. Future rentals vary between $137, 000 and $170, 000 annually.z Exhibits 10 and 11 summarize the information concerning the reporting of leases during the period 1949 through 1960. The first of these reflects the number of firms which reported lease details in vary- ing degrees: whereas the second exhibit summarizes the same data in percentage terms. At first glance these summaries appear to indicate considerable improvement in the extent of disclosure over this twelve- year period. Only 46 companies set forth details of long-term lease agreements during 1949, whereas 117 companies showed details in their 1960 annual report. The number of companies indicating long-term leases (without mention thereof) by reference to leaseholds or leasehold improvements fell from 66 in 1952 (first year noted) to only 37 in 1960. It is likely that some of this increase in reporting is really a reflection of the tremendous growth in leasing which was discussed in Chapter 2 rather than an actual improvement in the reporting. . At any rate, a close examination of Exhibits 10 and 11 indicates that current reporting still leaves a great deal to be desired. For example, in the 1Allied Stores Corporation, Annual Report, January 31, 1961, p. 19. ZThe American Hardware Corporation, Annual Report, December 31, 1960, p. 15. 46 . 33355004 333% UmflfimoU mo opafimGH Gamecock/w 330% 3075 mcoflfipm Auma 5.33 flow .umlmflwManoH. was mpcoafi mcficsgoooifl ”oohsom com 000 000 ooo 000 com ooe 000 000 000 mmm mmm H308 EN EN a: mum 3N ow». mom. is 03 cos 2;. m3. 333 ESHNSH man—soaps“ no: 0... wcfinuomou uoflfioz mmm wmm 2N mNN Mom 3N NMN Z: «A: com ms ow Hmpofism um 04 Hm mm mm om moH co co mosses nob/0.253 393mm“: no mgosommmfi o» oocouomou NE. 3095:» con—Goa “505.33 momma: Enouumsofi wcflmfipg ob an MN. aw vw mm me. Hm em a: om vm moouosu mflmpop wcfifiao ”:5. moms“: Enouumcofi mcwcoflhoz n: voH mo Ho No 3 mm vw «i. do om ow mommoa Egounmsofi mo mflmuop €38 mafluom com: momma wmmL 5mm; omod -mmoH wmoa mmod Nmofi Hmoa 0mm; oi: com: $.36 oi; mucoaoumum Hdwocmcflh poamflordnm 5 wooded Epoflumcod mcwmofiomwfl moficmmaov summed mo nongsz OH BHQHEXH 47 .ENOH ommusoouom Cw pommoumxo 0H fingxm So: moHSmflh "sousom N..\.m m.>m 0.0m mfim m.mm 56m >.wm ~10». me m.mm 0.“; N.ma mommoa Show uwcoa poumoflog .No 8. pouuomop .358 no??? monouB mcflucsoooda NE. pm>o>u5m mama H30» mo smoucoouonfi mcflmflpcfi .Ho op mappowon 33H. cos cos ooh cos ooa ooh ooh ooh ooh cos ooh 002 82 ogN 8.2 8NN «NN «.NN Ni. mg: N13. -- .: -- .8... .meaoemmmmaopoocogoufi E mesmflefi Rom 53 Nam 0.0m Ni. 2.... 4.2 2.: or; 83 0.8 mi. .333. wsssEoSn $80352 N.Nm 4.8. 2.2. 4.2. Nam mNa. Nam 4.3. 2.3. m5... 0.0m 83 3.8% £83.:st $2 $2 $2 $2 $2 $2 $2 32 N2: 32 om? $2 com: 5.2.3 0:; mucoaouMum Hmfiocmcflh poSmEQSnH a“ mommoim Euohnmcod wcwmoaomwfl mmfismmEoU oommod mo ommucoouonm : HHmHEXM 48 year 1960 only 52 per cent of the companies that indicated long-term leases set forth details thereof. This is actually lower than the 58 per cent that set forth details in 1949. During the intervening years this percentage has varied between a high of 50 per cent in 1950 down to a low of 31 per cent in 1951 and again in 1956. This means that during this twelve-year period, well over half of the firms failed to disclose details of their lease agreements. The inadequacy of the information presented is more apparent in Chapter V where attempts have been made to utilize the meager data presented for purposes of financial analysis. There seems to be little question that current reporting is deficient in certain respects. The above statistics would seem to bear this out. The cause of these deficiencies, however, is not quite so apparent. Some have said that requirements for reporting are themselves lack- ing. Others maintain that current requirements are satisfactory but that business managements have failed fully to comply with them. In order to evaluate these charges, let us take a look at the current rules for reporting of long-term lease agreements. Two bodies, the American Institute of Certified Public Accountants and the Securities and Exchange Commission, have been largely respons- ible for establishing standards of reporting. The first pronouncement of the American Institute of Certified Public Accountants, on the subject of leasing, Accounting Research Bulletin 38, was issued in October, 1949. Substantially the same material was contained in Chapter 14 of Accounting Research Bulletin 43 which was issued in June, 1953. In regard to disclosure of long-term leases in the financial statements, Bulletin 43 states: 5. The committee believes that material amounts of fixed rental and other liabilities maturing in future years under long- term leases and possible related contingencies are material facts affecting judgments based on the financial statements of a corporation, and that those who rely upon financial statements are 49 entitled to know of the existence of such leases and the extent of the obligations thereunder, irrespective of whether the leases are considered to be advantageous or otherwise. Accordingly, where the rentals or other obligations under long-term leases are material in the circumstances, the committee is of the opinion that: (a) disclosure should be made in financial statements or in notes thereto of: (l) the amounts of annual rentals to be paid under such leases with some indication of the ‘periods for which they are payable and (2) any other important obligation assumed or guarantee made in connection therewith; (b) the above information should be given not only in the year in which the transaction originates but also as long there- after as the amounts involved are material; and (c) in addition, in the year in which the transaction originates, there should be disclosure of the principal details of any important salemand-lease transaction. 6. A lease arrangement is sometimes, in substance, no more than an installment purchase of the property. 0 O O O 0 O O O 7. Since the lessee in such cases does not have legal title to the property and does not necessarily assume any direct mort- gage obligation, it has been argued that any balance sheet which included the property among the assets and any related indebtedness among the liabilities would be incorrect. However, the committee is of the opinion that the facts relating to all such leases should be carefully considered and that, where it is clearly evident that the transaction involved is in substance a purchase, the "leased" property should be included among the assets of the lessee with suitable accounting for the corresponding liabilities and for the related charges in the income statement. 1 In a footnote to Chapter 14, the committee states that: "Three years has been used as a criterion in some cases for classifying leases as short-term or long-term. ..2 1American Institute of Certified Public Accountants, Accounting Research and Terminology Bulletins (final edition; New York: American Institute of Certified Public Accountants, 1961), pp. 126-127. Chapter 14 of Bulletin 43 is reproduced in full in Appendix IV. zlbid., p. 126. 50 Regulation S-X, Form and Content of Financial Statements, issued by the Securities and Exchange Commission, contains requirements for reporting similar to those prescribed by the American Institute of Certified Public Accountants. Rule 3-18 (Commitments) reads as follows: (a) If material in amount the pertinent facts relative to firm commitments for the acquisition of permanent investments and fixed assets and for the purchase, repurchase, construction, or rental of assets under long-term leases shall be stated briefly in the balance sheet or in footnotes referred to therein. (b) Where the rentals or obligations under long-term leases are material there shall be shown the amounts of annual rentals under such leases with some indication of the periods for which they are payable, together with any important obligation assumed or guarantee made in connection therewith. If the rentals are conditional, state the minimum annual amounts.1 Rule 3-19 (General Notes to Balance Sheets) states in part: If present in regard to the person for which the statement is filed the following shall be set forth in the balance sheet or in notes thereto: (g) Contingent liabilities. --A brief statement as to con- tingent liabilities not reflected in the balance sheet shall be made. In the case of guarantees of securities of other issues a reference to the appropriate schedule shall be included.2 While both the American Institute of Certified Public Accountants and the Securities and Exchange Commission seem to provide a great deal of latitude as to method of disclosure, the fact that both of them have failed to take a stand against footnote disclosure, has resulted in 1United States Securities and Exchange Commission, Regulation S-X, Form and Content of Financial Statements (Washington, D. C.: U. S. Government Printing Office, 1961), p. 5. zlbid., pp. 5-6. 51 the almost universal adoption of this technique. Those companies that have reported long-term leases have generally done so in notes to the financial statements rather than in the body thereof. Causes of Apparent Deficiencies What are the causes of these deficiencies? Are the standards for reporting themselves deficient, or is it merely a case of failing to fully implement these standards ? Actually, it appears that deficiencies exist in both of these areas. Standards are Deficient Current requirements are rather vague. For example, the phrase in Bulletin 43 which states "material in the circumstances" is not exact- ing and probably has resulted in the failure of many firms to disclose their leases. The statement "disclosure should be made in the financial state- ments or in notes thereto" is another example. Since firms tend to report only the minimum amount of information necessary, they have almost universally adopted the footnote disclosure. It has been argued that if this was the intent of the Committee on Accounting Procedure, then it should have been statedmore “explicitly. ' The, wording "inthe balance sheet or footnotes referred to therein" as contained in Regulation S-X would also seem to leave room for choice of methods. However, the Securities and Exchange Commission will not allow a firm to include leases in the 1 balance sheet totals. If it was their intent to confine disclosure to the footnotes, then a statement to that effect would have been in order. 1Letter from Andrew Barr, Chief Accountant, Securities and Exchange Commission, Washington 25, D. C., January 3, 1962. 52 Another criticism of current standards is that they do not require enough information to enable the reader to determine the full financial implications of leases. For example, none of the annual reports examined in this study contained sufficient information to enable the reader to capitalize the company's lease obligations in order to determine the present value of the obligation. The implications of this deficiency will be discussed in Chapter V and VI. Standards Are Not Being Complied With In addition to the fact that current requirements are apparently lacking, there is evidence that the standards which have been established have not been fully complied with. This is apparent in a study which was made by Lloyn Vann Seawell in which he examined a large number of corporate annual reports to determine the extent of compliance with practices suggested in the American Institute of Certified Public Account- ants' Accounting Research Bulletins. Seawell's results in regard to long-term leases are reproduced in Exhibit 12.1 Note that in each of the three years the non-compliance approached fifty per cent. In regard to the 1956 reports, Seawell followed up with letters to the auditors to have them ”justify" the apparent non-compliance and adjusted his 1956 figures to reflect the result of the replies. The adjusted figure, however, still disclosed twenty-five per cent non-compliance. This study certainly indicates that current requirements are not being met. 1The following criteria were established by Seawell for evaluating compliance with Chapter 14, AccountingResearch Bulletin 43: Criteria for Full Compliance. In order to earn a rating of Full Compliance, the presentation must have met all of the following criteria: 1. Disclosure must be made of the amounts of annual rentals to be paid under long-term leases. 53 Rationale Behind Current Practices The current accounting practice of not including leased property among the firm's assets or the related lease obligations as liabilities is based upon three main legal arguments. In the first place, it is argued that legil title to the leased property rests with the lessor and that any attempt to include it on the balance sheet would be erroneous and would misstate the legal facts. 2. Disclosure must be made of the term of the leases or their expiration dates. 3. Disclosure must be made of obligations assumed or guarantees made in connection with long-term leases, or statements are made indicating that no important obligations were assumed and that no important guarantees were made. 4. Disclosure must be made of annual rentals, term of the leases or their expiration dates, obligations assumed, and guarantees made in each year subsequent to the year in Which the contracts originated. 5. Disclosure must be made, in the year in which the contracts originate, of the principal details of the Sale-and-lease-back transaction. 6. Where it is clearly evident that the contracts are in substance purchase arrangements, the "lease" properties must be in- cluded among the assets of the lessee with suitable accounting being adopted for the related liabilities and payments to the 'qessor." Criteria for Apparent Compliance. An evaluation of Apparent Compliance was given to those presentations which met all requirements of Full Compliance except that no disclosure was made of obligations assumed or guarantees made in connection with long-term leases, nor was there any indication of the existence of such obligations or guarantees. Criteria for Non-Compliance. An evaluation of Non-Compliance was given to those presentations which apparently violated any one of the six Full Compliance criteria. The Non-Compliance rating was given in those instances where the balance sheet disclosed "leasehold improve- ments, ” but failed to disclose additional information relating to rentals and term of leases. Criteria for Apparent Non-Coverage. The rating of Apparent Non- Coverage was given to those annual reports which gave no indication of there being any long-term leases in the company's operations. It is prob- able that long-term leases existed in certain instances, but were not dis- closed in the annual reports. It was deemed impracticable to attempt to determine the extent of such omissions. 54 EXHIBIT 12 Evaluation of Compliance With AICPA Research Bulletins Regarding Reporting of Long-Term Leases-4. 1954 1955 1956 _ Evaluation Rating Number Per Cent Number Per Cent Number Per Cent Full compliance 30 44. 1 33 47. 1 32 48. 4 Apparent compliance 4 5. 9 5 7.1 3 4. 5 Non-compliance 34 50.0 32 45.8 31 47.1 Totals 68 100.0 70 100.0 66 100.0 Apparent non-coverage 187 185 189 Totals 255 255 255 *Source: Lloyn Vann Seawell, ”An Evaluation of Selected Industrial Corporation Annual Reports for Compliance with Accounting Research Bulletins of the AICPA's, " unpublished D. B.A. dissertation, School of Business, Indiana University, 1958. 55 The second legal argument in favor of current accounting prac- tice relates to the manner in which other contractual obligations are treated in the books of account. Under current accounting treatment, these obligations are not recorded in the books or shown in the financial statements except insofar as they represent claims against goods or services which have already been received. For example, employment contracts, material and equipment purchase contracts, construction contracts, pension and retirement plans, royalty obligations, and other contracts, all of which are legal and binding obligations, are typically not regarded as "debt" and do not constitute "liabilities" as the terms are usually used in the balance sheet. The similarity between the lease obligation and other contractual agreements may be seen from the following statement by the vice-president of a New England bank: It has been aptly suggested that there is no more excuse for cluttering up the balance sheet with . . . leases than for doing the same thing with future obligations to pay wages -- a commitment similar in that both will be paid only if the company stays in business.1 The senior editor of Dun and Bradstreet, Inc. , emphasized this same point in a personal letter in which he stated: We never adjust the financial statements to reflect leases any more so than we would adjust the balance sheets to reflect potential future charges to earnings on account of payrolls, administrative salaries or other long-term charges incurred under the normal Operation of a business. Contrary to feeling that of [sic] such lease obligations should be shown as liabilities, we can only conclude that to show an obligation incurred under long-term contract as an obligation may serve only to mislead and confuse. While it is true that a lease implies a future obligation, such an obligation would be liquidated in fact out of income and not out of assets. If the terms lBennett R. Keenan, "Financing a Leasing Corporation, " a paper submitted in partial fulfillment of the requirements of The Stonier Graduate School of Banking conducted by the American Bankers Associ- ation at Rutgers University, June, 1960, p. 14. 56 of a lease are not going to be met later on, it is either because the concern itself has become insolvent in which case the entire matter of obligation incurredis up in the air or the lease is going to be transferred under subleasing arrangements. I do not presume to speak for the Dun 81 Bradstreet Organization officially on this matter. Accounting methods and techniques are not in our province. However, I can point out that the problem of financial analysis would be complicated if account- ants generally were to follow through with this proposed change. If a lease-hold obligation is to be shown as a debt than [sic] it would be presumed that the income from which the lease-hold terms are to be met would be shown as an asset.1 The third argument upon which current practices rests relates to the differences between debt and lease obligations as recognized by the courts of law. Most leases provide thatin the event of default on any of the lease provisions the entire amount of rent payable under the lease shall be immediately due and payable. However, in spite of these default provisions, the courts have usually refused to recognize the claims of the lessor for the total amount of unpaid rentals. In the case of Kothe, Trustee, v. R. C. Taylor Trust the Supreme Court of the United States ruled that such an amount was ". . . so disproportionate to any damage reasonably to be anticipated . . . that we must hold the "7‘ Similarly, in the case of provision is for an unenforceable penalty. the Commissioner of Insurance v. Massachusetts Accident Company the court ruled that ". . . where a lease contains many covenants of varying importance . . . the sum designated to be paid upon a breach of any of these covenants is a penalty and not liquidated damages. "3 1Letter from Richard Sanzo, Senior Editor, Business Education Division, Dun and Bradstreet, Inc. , New York 16, New York, November 27, 1961. 2.280 ms. 224 (1930). 3310 Mass. 769, 39 N.E. 2d. 664 (1942). 57 In those instances where a firm that is bankrupt defaults on a lease, the Bankruptcy Act governs the amount of the lessor's claim. In the event of reorganization under Chapter Ten, the act provides that: The claim of the landlord for injury resulting from the rejection of an unexpired lease of real estate or for damages or indemnity under a covenant contained in such lease shall be provable, but shall be limited to an amount not to exceed the rent, without acceleration, reserved by such lease for the three years next succeeding the date of the surrender of the premises to the landlord or the date of reentry of the landlord, whichever first occurs. .1 Similarly, in the event of bankruptcy the act provides: That the claim of a landlord for damages for injury resulting from the rejection of an unexpired lease of real estate or for damages or indemnity under a covenent contained in such lease shall in no event be allowed in an amount exceed- ing the rent reserved by the lease, without acceleration, for the year next succeeding the date of the surrender of the premises to the landlord or tzhe date of reentry of the landlord, whichever first occurs. Presumably, the lessor would likewise be limited to damages in the case of chattel leases and would not be permitted to recover the entire unpaid rental.3 These differences in the event of bankruptcy are made clear in the following statement: A lease has, to be sure, certain elements also found in debt: it is a promise to pay a fixed amount over a certain period. It lacks, however, one feature of debt, at least, that to a creditor should explode any notion that a lease is debt. In the event of bankruptcy of the debtor, a debt is normally recognized in full as a claim; in bankruptcy of a lessee this is not the case.‘ 1Section 202, Chapter 10, The Bankruptcy Act. 2Section 63a(9), Chapter 7, The Bankruptcy Act. 3Alvin Zises, "Disclosure of Long-Term Leases, " The Journal of Accountancy, Vol. CXI (February, 1961), p. 39. 4Keenan, pp. <_:_i_t., p. 15. 58 In summary, the proponents of not disclosing long-term leases in the body of the balance sheet rest their case primarily on legal grounds. In respect to the leased property, they point out that legal title rests in the lessor and, therefore, it cannot be shown among the assets of the lessee. As to the obligation, they state that although the contract is legal and binding, the courts will not regard it as fixed in amount in the event of financial difficulty and therefore it should not be shown as a liability of the lessee. They also point out that many other obligations are similarly not shown on the balance sheet. While this group generally admits some inadequacy in current reporting of long-term lease agreements, they feel that the solution lies in expanding footnote disclosure rather than abandoning it. They suggest that the American Institute of Certified Public Accountants, the Securities and Exchange Commission and other interested bodies determine what information is desired. When this information is specified, footnotes can readily be expanded for its inclusion. Current inadequacy, they say, is due only to incomplete directions. CHAPTER IV PROPOSED CHANGES IN FINANCIAL STATEMENT REPORTING Propos ed Changes The inadequacies in current reporting of long—term leases which were discussed in Chapter 111 have suggested that footnote disclosure is inadequate and should be abandoned. Three alternative proposals have been suggested: preparation of a supplementary schedule of con- tractual commitments, capitalization of the lease rentals with the amounts shown short, and capitalization of the lease rentals with the amounts included in the balance sheet totals. Supplementary Schedule The first major proposal for improving current reporting calls for the preparation of a separate schedule. Under this form of report- ing, the leases would be only mentioned in the body of the financial statements (no amounts) with a reference to a separate schedule on which the required details would be shown. Alvin Zises, President of Bankers Leasing Corporation, has suggested this type of disclosiire. His "Schedule of Material Contractual Commitments (S-X Rules 3:18 and 3:19)" is reproduced as Exhibit 13. The supplementary schedule approach has received the support of a number of groups, including the Financial Analysts Federation. In a personal letter, William C. Trapnell made the following statement: 59 60 ‘ Exhibit 13 Schedule of Material Contractual Commitments (S-X Rules 3.18 and 3.19) Amounts Contracted or Estimated for Each of Next Minimum Remaining A t A t P ' d 22.2" 5 Years and for Each of Three 5-Year Periods Beyond 3:3,“? (3111:):20 m Type of this Year Year Year Year Year Years Years Years ment if De- Date of Commitment Year 1 2 3 - 4 5 6-10 1 1-15 16-20 terminable' Report Purchase and Repurchase for: (a) Investments (b) Fixed Assets (c) Inventory and Supplies (d) Other Construction Long-Term Leases Royalties Pension and Retirement Employee Contracts Guarantees Contingent Liabilities Other (Explain) Totals 'The minimum balance payable, in each type of commitment, may be discounted over the remaining period by a stated per annum percentage. Where such minimum balance is discounted, state the percentage used in each case. Where amounts both paid and payable for any type of commitment are not material, a statement to that effect for any such ’type of commitment will suffice. Show amounts separately for each type of commitment if amounts paid or payable are material. Any pertinent information of a material nature regarding any commitment should be furnished within footnotes to the schedule. Taken from Alvin Zises, "Disclosure of Long-Term Leases, " The Journal of Accountancy, Vol CXI (February, 1961). p. 45. Reproduced by permission offie author. 61 The Government Relations Committee of the Financial Analysts Federation, of which I am Chairman, has taken a position opposing the capitalization method and favoring a sup- plementary schedule. We intend to recommend to the S. E. C. that such a schedule be required in registration statements and current reports, but we are withholding the preparation of any Specific proposals pending the release of a research report on the general problem for the American Institute of Certified Public Accountants prepared by Professor John Myers of Northwestern University. We have talked informally with members of the S. E. C. staff about this matter and I believe that some of them are sympathetic with our attitude. However, I do not know what formal position the Commission or any of its departments may take. Generally speaking, investors, as represented by financial analysts, want more adequate disclosure without tampering with the balance sheet, while the capitalization proposal is backed only by the group of accountants and by some investment bankers and academicians. Business, on the other hand, does not want additional reporting burdens. One of our problems is to suggest a schedule which will not be unduly burdensome, yet will provide sufficient information for an accurate evaluation of financial con- dition. 1 Such a schedule would certainly be an improvement over current practice. However, it would fail to overcome most of the criticisms of footnote disclosure. After all, schedules are really just an expanded form of footnotes; and, where one is inadequate, the other can hardly solve the problem. Supplementary schedules would be acceptable to most persons who favor current methods of disclosure but would not be acceptable to those who favor capitalization. There is no more reason for showing leases in a separate schedule than there is for doing the same thing with cash. Both items have a profound effect on the balance sheet and should be included therein. lLetter from William c. Trapnell, Second Vice-President and Secretary, Provident Mutual Life Insurance Company of Philadelphia, and Chairman of the Government Relations Committee of the Financial Analysts Federation, September 27, 1961. 62 Capitalization with AmountLShown Short The second major proposal for improving current reporting would be to capitalize the leases and include them in the body of the balance sheets with the amounts shown "short. " Capitalization would be accomplished by discounting the total rentals payable under the lease to their present value. The capitalized figure would be shown under the caption "Property, Plant and Equipment, " among the firm's assets. The corresponding credit would be shown in the liability section of the balance sheet, segregated according to "current" and "long-term" portion. These figures would then be double ruled and would not be included in any of the totals of the statement. An example of the "short" procedure is seen in the annual report of the Fairbanks Whitney Corporation which is reproduced in Exhibit 14. This proposal is acceptable to the Securities and Exchange Commission, while capitalization with the amounts included in totals is not. Arthur Andersen and Company suggest that this technique ”. is preferable to footnote disclosure, and might be justified as a step in the transition to the proper recording of lease obligations [which they feel is by capitalization]. "1 However, the "short" technique is completely unsatisfactory and actually may be misleading. At first glance it appears that the leases have been included, and it is only after careful examination (and the help of an adding machine) that the reader finds they are just there for "looks. " The average reader of a financial statement is not accustomed to checking its mathematical accuracy. When he sees a figure on a balance sheet, along with the opinion of a Certified Public Accountant, he assumes that the figure "counts" and he has every right to assume just that. 1Arthur Andersen 81 Co. , Accounting and Reporting Problems of the Accounting Profession (New York: Arthur Andersen and Co. , 1960), p. 25. 65 EXHIBIT 1.} Ill" i‘tuJ ubUUiBlARIF-S ." inf-“2!! F.'n"r."l‘.’. ‘sy'f an --ov_v co : chaos-lasa‘boh‘) ‘Iod;;ci—n Li..- Unit-isn‘t“! (funny; fi"',:_- 321:] rtfir Ovrw-n ”PT-n . “A . :-- r Ubihle—i WAELE} -_,‘!r “Us. Don-n-.. _U: EHO- .Ol. izuu [KW-Jigdg 707?: a SUO U '.u 1960 2959 Current assets: Cash ............................................................................................ S 1-,077.6(5 S 14 400,009 Government securities, at cost .................................................... . 79.586 1 182,516 Receivables, less reserve of $551,331 and $535,755, respec- tively ........................................................................................ 28,053 149 24,825,856 Inventories, at lower of cost (first-in, first-out basis) or market-— Raw materials and supplies ................................................ 8,491,477 9,445.5.45 Work in process and finished parts ...................... . ............. 35,928,147 37,321,883 Finished goods .................................................... é, .............. 7,917,651 10,162,379 Total inventories ................................................ 8 52,337,275 8 56,909,507 Prepaid expenses ........................................................................ 1,330,354 1,077,880 Total current assets ............................................ 8 93,938,029 8 98,396,368 Property, plant and equipment, at cost ................................................ 8 91,301,072 8 91,144,470 Less—Reserves for depreciation, depletion and amortization 47,250,548 45,459,699 8 44,050,524 5 45,684,771 Rights to use of leased facilities, at December 31, 1960, at discounted amount of related long-term rental obligations—see contra ...... $12,700,030 Other assets: Mortgages and notes receivable .................................................. S 2,729,248 8 2,879,411 Investments in joint ventures ...................................................... 1,509,278 830,620 Government securities, pledged as security ................................ 125,972 340,608 Debt discount and other deferred charges ................................ 840,901 835,236 3 5,205,399 $143,193,952 3 4,885,875 . 148,967,014 64 Tm: “NWT? 129(0)? 1 :3 ' 1 1 11 0111;: lILNLJ/U ! xiii $9 smug. .n' ruling: ‘1'~Lr-cn ("1‘4 - '11? In": t rm" "arrnrnr’a r ~r-w-—-==-\~——~7 1 id .- “duh—dad .d-‘hiidu liabliiiies Current liabilities: Loans payable, less $400,000 cash collateral, secured by 40,000 shares of Fairbanks, Morse & Co. common stock, and notes payable .............................................................................. Accounts payable ........................................................................ Accrued expenses ........................................................................ Current maturities of long-term debt .......................................... Reserve for Federal and foreign income taxes ............................ Total current liabilities ........................................ Reserves and deferred credits: Deferred Federal income taxes .................................................... Reserves for losses on long-term leases, e1: ............................... Minority interest in subsidiary comp nies ................................ Long-term debt, excluding amounts due within one year (Note 2) Rental obligations under long-term leases, at Decem- ber 31, 1960, discounted over period of leases, (including $808,000 due within one year) see contra. S 12,700,000 Capital stock (Notes 3 and 4) and surplus (Note 1): Cumulative preferred stock, par value 840 per share, authorized 369,672 shares, outstanding 369,372 shares, after deducting 300 shares in treasury, at December 31, 1960 ........................ Common stock, par value $1 per share, authorized 10,000,000 shares, outstanding 7,436,608 shares, after deducting 178,009 shares in treasury, at December 31, 1960 ................ Capital surplus ............................................................................ Earned surplus (deficit) ............................................................ 1960 7,015,817 8,728,974 6 245,465 2, 125, 999 2,599,667 to '0‘ \1 15,922 2,050,120 4,795,087 7,905,795 14,751,002 31,793,125 14,774,880 7,436,608 47,683,225 39,190 S 69,933,903 $143,193,952 \ .41.] uhldIHu—Jid 2,900,000 8, 1 29,375 7,205,825 2. 3 84,200 3284,2212 U: it 23.703,612 1,755,144 5.461307 8,038,779 15,945,230 {/3 39,: .5,480 14,”: O I ,U‘i’O 7 ,436, 602 66,312,468 (18,293,4l8) 3 70,242,692 S 148,967,014 65 Capitalization with Amounts Included in Totals The third and most significant proposal provides for the capitali- zation of lease rentals and for inclusion of these amounts in the body of the balance sheet as well as in the totals thereon. Because this proposal provides the best solution to the problem of inadequate report- ing of long-term leases, the remainder of this dissertation will be devoted thereto. From here on, the term "capitalization" will be used to refer strictly to this proposal and will not include the "short" tech- nique described previously. Selection of Interest Rate Capitalization is accomplished by discounting the rentals payable during the term of the lease to their present value at some "implied rate" of interest. The selection of the "true rate" implied in the lease is of paramount importance and is essential to assure accurate capitali- zation. Although a number of rates may be discussed during the lease negotiations, the "true rate" is often concealed. Nevertheless, it can easily be computed by comparing the cost (or cash price) of the asset with the total rental payable over the term of the lease. The difference between these two figures represents interest. If this amount is divided by the number of years the lease will run, the quotient represents the average interest. When this latter amount is divided by the average investment, the result represents the annual rate of interest. The ease of computing this implicit interest rate may be seen by looking at the following lease: A plant was built by the XYZ Company to its specifications at a cost of $5, 600, 000. The building had an estimated useful life of 40 years. Upon completion, the building was sold at cost to an insurance company under a sale-and-lease-back agreement. The lease had an original noncancelable term of twenty years during which it called for annual rentals of $420, 000. The XYZ 66 Company had options to renew the lease for an additional forty years at the following reduced rentals: first 5-year renewal at $196, 000 per year; second 5-year renewal at $168, 000 per year; next six renewals of 5 years each at $112, 000 per year.1 Utilizing the above information, we find that total rent payments over the initial term of the lease will amount to $8, 400,000. This amount will include $5,600, 000 return of investment plus $2,800, 000 interest. The average interest over this twenty-year period will amount to $140, 000 per year ($2,800, 000 — 20 years) while the average invest- ment will be $2, 940, 000 ([$5, 600, 000 + $280, 000];- 2). The interest rate implied by these calculations would be 4. 76 per cent. The above calculations, however, have ignored a very important part of the interest. Under the provisions of the lease agreement, the lessor will own the building at the end of the twenty-year period and the XYZ Company will have continued use of the building after that date only by paying additional rentals/7‘ In other words, in order to have use of the building during its entire useful life (estimated at forty years) the XYZ Company must pay $2, 940, 000 in addition to the $8, 400, 000 paid over the initial term of the lease. Since this is an amount in excess of the principal, it represents additional interest.3 The total payments 1This example is based on an actual lease. Only the name of the lessee is fictitious. 2Of course, the XYZ Company has the option of abandoning the property at the end of the initial twenty-year period. If it does this, however, it is giving up the use of an asset which it has already paid for and which has a remaining life of twenty years. This means that the lessee in effect will be required to make an additional rental payment at the end of the twentieth year which will be equal to the fair market value of the property at that date. 3‘The intent of the lessee at the time the lease is negotiated should govern the treatment used. If he intends to lease the building for its entire useful life, then the rentals paid during the periods of renewal should be treated as additional interest. If the lessee intends to lease the property for only a portion of its useful life, then the estimated fair market value of the property at the date the lease is to be terminated 67 required to have use of the building during its entire useful life will amount to $11, 340, 000. These payments will include $5,600, 000 return of principal and $5, 740, 000 interest. The interest rate implied by these calculations is 5.61 per cent.1 This rate represents the true interest rate implied in the above lease agreement. Accounting Entrie s The present value of the lease rentals (which will always equal the cost or cash price of the asset at the beginning of the lease term) is placed on the books by the following entry:2 should be treated as additional interest. In the illustration used here, the entire useful life of the building was assumed to be applicable. The renewal options beyond this estimated useful life were ignored because these options will never be exercised based upon current estimates. 1The computation of the implied interest rate is more complex than it was under the previous illustration inasmuch as the rentals are not uniform over the duration of the lease. The interest rate is computed by use of the following formula: 1 - ' 2° 1 " ——"25 1 “—_-"‘20 $5,600,000 -.: $420,ooo<__(;l_+1)_.>+ $196,000 (1+1) _ (1+1) 1 1 1 1 " '—-30 - -—-.-25 + $168,000 __.—931 _ 0+1) 1 1 l 1 1 1 ' ——-10 " . o + $112,000 < (11“) _ (__(L3 1 zThe account titles used in the illustrative journal entries are those suggested by Arthur Andersen and Company in their publication Accounting and Reporting Problems of the AccountingProfession. 68 Dr. Rights to use of leased property $5,600, 000 Cr. Rental obligations under long-term leases $5,600,000 The account ”Rights to use of leased property" should be shown on the balance sheet as a fixed asset and the balance in that account should be amortized over the term of the lease, just as other fixed assets would be depreciated. The periodic entry required to accomplish the amortiu zation is as follows: Dr. Rent Expense -- leased property $140, 000 Cr. Rights to use of leased property $140, 000 The account "Rental obligations under long-term leases" would be shown on the balance sheet as a liability. The portion payable within a year would be listed under the "current" caption and the remainder would be carried under "long-term" liabilities. The lease liability account would be adjusted at the end of the year and the periodic interest recorded by the following entry;1 Dr. Rental obligations under long-term leases $105, 858 Dr. Interest charges 314,142 Cr. Accrued rent payable $420, 000 The liability established in the above entry would be liquidated at the time the rentals are paid. Each rent payment would thus include an element of principal and an element of interest. The entry to record the periodic rental payment is as follows: Dr. Accrued rent payable $420, 000 Cr. Cash in bank $420, 000 1The amounts shown here are applicable the first year only. The entry, however, would remain the same from year to year with only amounts changing due to the declining balance of the lease liability. 69 The journal entries that would be required over the entire forty- year period based upon the capitalization technique described previously are summarized in Exhibit 15. Note that the lease transaction has been separated into its operational and financial elements. The cost of the lease asset is spread over its expected useful life (forty years) in some systematic manner. The method of amortization which has been used here is the straight line method, but this has no bearing on the theory presented. Any acceptable method of amortization could have been used with equal application. The significant point is that the amortization of the asset has no relationship to the method of financing employed. The lease rentals have been applied first to interest and then to principal in accordance with the U. S. Rule. The interest charges were computed by applying the implicit rate of interest (5. 61 per cent) times the declining balance of the lease liability. Rationale Behind Capitalization Capitalization is not a proposal which has evolved independently of accounting theory and which "strikes at the very foundation of accounting, " as some have charged. In fact, quite the reverse is true. The proposal actually has its roots deeply implanted in the body of accounting theory and closely parallels the treatment which is given similar financial transactions . The Nature of Accounting Before considering the reasoning behind the capitalization proposal, it is essential to have an understanding of the nature of accounting. The Committee on Accounting Terminology of the American Institute of Certified Public Accountants has defined accounting as follows: 70 mme.mew.2 Aooo.o~ev Moe.mom nom.nmn Aooo.oenv ooo.o42 om emo.eea.m Aooo.omev mee.~w~ emm.em2 Aooo.oefiv ooo.oen on see.eee.m Aooo.omev ewe.eem eem.~m2 Aooo.oeav ooo.oen an mNm.eae.N Aooo.omev mom.mmm eo4.ee2 Aooo.oe2v ooo.oe~ e2 emo.wee.~ Aooo.o~ev mmo.oem Neo.ee2 Aooo.o42v .ooo.o42 e2 eeo.wo~.m Aooo.omev mwm.e~N N2».Non Aooo.oeav ooo.oe~ m2 Nmm.mme.m Aooo.omev m2~.mam mwe.eom Aooo.oenv ooc.oe~ 42 eem.ome.m Aooo.omev www.mom enm.e2~ Aooo.oenv ooo.oea m2 0mm.emw.m Aooo.omev emo.mea 240.5NN Aooo.oenv ooo.oea N2 eom.eeo.e Aooo.omev one.Nw2 oeN.PMN Aooo.oeav ooo.oen 22 020.0mm.e Aooo.o~ev moo.men mee.ee~ Aooo.oeav ooo.c42 on emo.moe.e Aooo.omev mnm.me2 mw2.emm Aooo.oenv ooo.oe~ o emw.eem.e Aooo.owev 422.mm2 ewm.eeN Aooo.oeav ooo.o42 m mme.ame.e Aooo.omev mew.een mN2.meN Aooo.oeav ooo.oe~ e www.mew.e Aooo.omev meo.em2 eme.owm Aooo.oenv ooo.oe~ e Hoe.eoo.m Aooo.omev ewe.2m2 enm.mm~ Aooo.oeav ooo.oen m emm.em2.m Aooo.omev Hee.e~2 eom.mom Aooo.oeav ooo.oen e mem.eem.m Aooo.omev weo.wnn Mme.nom Aooo.o42v ooo.oen m eem.mwm.m Aooo.omev eee.nna eom.wom Aooo.oenv 000.042 N N42.eev.mm Aooo.omewv www.m02 N42.enme Aooo.oenv ooo.oena 2 Aooo.ooe.mmv ooo.ooe.me o Joules .325 ammU ewfidormfid ommoA .mm£0 €06.8ch “cameos ommoA @me Daemon: “com use? 1.3.4 owned mo UGM a“ oucmadm wcmcfidgom Egon“. umowurnoh HOW owned >cma§oU wa coufinuamu kebab ponfisvom morflcm #93505 mm HHQHEXH 71 He- Nao.eo2 Nme.eom mam.2oM mmm.nom eom.eee omm.emm aeo.mme mem.eoe mew.eee ee5.emm emm.eme eme.~eo.2 oe~.mea.2 Hee.mem.2 www.4mm.2 ~N2.wee.n ome.mem.2 ome.eee.2 eeo.eea.n Aooo.~22v Aooo.N22v Aooo.~HHv Aooo.manv Aooo.~HHv Aooo.~22v Aooo.~HHv Aooo.~22v Aooo.~n2v Aooo.~22v Aooo.me2v Aooo.menv Aooo.wofiv Aooo.we2v Aooo.woav Aooo.ooflv Aooo.eo2v Aooo.eo2v Aooo.eonv Aooo.oo~v mmo.eon ome.o02 ewo.mo mmo.oo mmm.mm emm.om eme.ee eem.~e mmm.me now .46 oe4.422 oom.wo2 mme.~02 Hw2.eo mmo.~o mee.m22 eoe.eon new.non one.ee 4mm.ne neo.m owm.22 42o.e2 meo.am nee.eN eem.2m mem.mm eme.em wee.me mon.e4 omm.mm one.em eem.me onw.oe Nwo.me emm.~m mom.mw ooh.em 2mm.oo eee.eon Aooo.oenv Aooo.o42v Aooo.oesv Aooo.oenv Aooo.o42v Aooo.ovav Aooo.ownv Aooo.ovnv Aooo.oenv Aooo.oeav Aooo.oenv Aooo.oeav Aooo.o42v Aooo.oenv Aooo.oenv Aooo.oenv Aooo.o42v Aooo.oenv Aooo.oenv Aooo.o42v ooo.oen ooo.oen ooo.o42 ooo.oen ooo.o42 ooo.oen 000.042 ooo.oen 000.942 ooo.o42 ooo.oen ooo.oed ooo.oen ooo.oen 000.042 ooo.oen ooo.oeH ooo.oen ooo.o42 000.042 ow. mm mm mm a, 6 mm mm mm mm Hm om mm mm NM om mm mm mm mm Hm 72 Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.1 It is important to note that the committee regards accounting as an art, not a science. What we call ”principles of accounting, " then, are not eternal laws which must endure forever but rather temporary guides which should evolve with the development of the art. A second point that is essential to the reasoning contained herein is that accounting is a profession. Although this is a debatable point, it is not within the scope of this study.2 We shall assume here that the certified public accountant does act in a professional capacity in render- ing an opinion of the adequacy of financial statements. He is holding himself out to the public as an expert in his field. In spite of the fact that his “certificate" does not constitute a guarantee, it is nevertheless regarded as authoritative. This means that the C. P.A. must not be swayed by what special interest groups might suggest is for the public welfare but must prescribe that which his professional training and experience dictates. Actually, the financial statements issued by a firm are the repre- sentations and responsibility of its management. The statements are usually prepared by industrial accountants who often are not certified. The statements are then presented to a public accountant who, in 1American Institute of Certified Public Accountants, Accounting Research and Terminology Bulletins, p. 9. 2Some excellent articles have been written on this subject. See for example: A. B. Carson, "Profile of a Profession, " The Journal of Accountancy, Vol. XCVII (January, 1959); E. Michael Howarth, "General Recognition of Accountancy as a Profession, " Canadian Chartered Account- ant, Vol. LXIX (December, 1956); A. C. Littleton, "Characteristics of a Profession, " New York Certified Public Accountant, Vol. XXII (April, 1952); and Charles P. Rockwood, "The Changing Image of a Profession, " The Journal of Accountancy, Vol. CX (October, 1960). 73 connection with an audit of the books of account, is asked to render an opinion regarding the fairness of the presentation of the financial state- _ments. Even though these statements are actually not presented by the C. P.A. , he nevertheless holds veto power over them. In deciding what information the financial statements should contain, the industrial accountant must look closely at the standards employed by the C. P.A. No alert management would present financial statements for a professional opinion unless they felt the statements would pass the scrutiny of the C. P.A. For this reason, it is the certified public accountants and the national organization which speaks for them that must assume responsi- bility for financial statement deficiencies. It is in this framework that the movement to change techniques for lease reporting has evolved-~first, that accounting is an art and is not based upon a body of irrevocable rules; and second, that accounting is a profession, capable and qualified to meet the changing needs of business. Donald R. Gant, placed the responsibility directly where it belonged when he stated: If there is to be any broad change, the impetus must come from the group which, by failing to take action up until now, has allowed the problem to reach its present proportions-~the public accounting profession. The vital role which accounting plays in the decisions of both corporate financial managers and investors cannot be denied. But it is also true that the accountant's devotion to maintaining a thread of consistency from year to year often makes changes in "generally accepted accounting principles" slow in coming about, with the result that these principles are sometimes in conflict with economic logic. And certainly the soundness of financial policy which subordinates common sense to accounting convention must be questioned. Yet this appears to be the principal explanation for the trend toward lease financing. Accounting standards which were appro- priate for the treatment of commercial leasing have proved wholly inadequate to cope with the growing challenge offered by the adaptation of the lease as a financing instrument. Out of these 74 inadequacies has come a curious kind of logic which argues that the existence of an asset can be determined or denied by a ledger entry, and that a promise to pay becomes an obligation only if it is reflected in figures on a balance sheet. This sort of rationalization may serve to ease the conscience of a management that is opposed to debt, or that has seen the amount of its debt climb to a disturbing level. But, unfortunately, it ignores certain basic economic facts of life. Every business requires certain fixed assets, and the choice available to it is not whether to finance these assets but how to finance them. Lease financing is one way of acquiring assets, but it is a form of borrowing-min most cases, a very expensive form. Like all types of borrowing, lease obligations draw on the credit of the borrower, and credit is not a bottomless well. If it is used in one form, it is not available to be used again in another. Accounting deficiencies may have made it possible for some com- panies to have their cake and eat it, too; however, there is reason to believe that the advantage will be short-lived. There is evidence of a growing awareness among investors and financial analysts of the significance of lease commitments, and this must inevitably be reflected in accounting changes. 1 The Nature of the Lease In accepting this challenge, the advocates of capitalization have suggested a plan which would look through the legal details of the lease and record the transaction according to the logic dictated by the financial and economic facts. Capitalization recognizes the fact that leasingis just another means of financing, similar in many respects to debt financing. This view may be summarized as follows: . . . it should be apparent that a lease or leaseback is nothing more than another form of financing, albeit an expensive one in many cases. When one enters into a lease or leaseback contract, the action taken is equivalent to borrowing money, and, in effect, the lease liability is tantamount to long-term debt. In proper perspective, it could really be regarded as an integral 1Donald R. Gant, "Illusion in Lease Financing, " Harvard Business Review, Vol. XXVII (March-April 1959), p. 142. 75 part of the capital structure. Yes, entering a lease or leaseback is substantially the same thing as borrowing money. Certainly the credit strength of the enterprise is dissipated just as quickly and just as effectively through the entering of lease hold commit- ments as it is through the addition of debt. Through the eyes of the critical analyst, there is little difference between the two, i. e. , debt and lease liabilities, and both result in fixed charges in which the essential ingredients are depreciation and interest. 1 Exhibit 16 compares some of the more common characteristics of a lease with those found in a typical bond agreement. Note that each provision in the financial lease has its counterpart in the bond agreement. The leasing companies themselves have recognized the similarities between leasing and borrowing and accordingly have in many instances placed restrictive provisions in their lease agreements which are com- parable to those found in conventional debt instruments. Examples of these restrictive provisions in the debt and lease agreements of major airlines are included in Appendix V. Capitalization and the Balance Sheet Inclusion of the account "rights to use leased property" among the firm's assets as suggested earlier in this chapter would seem to be within the scope of the American Institute of Certified Public Accountants' definition of the term "asset" which follows: The word asset, is not synonymous with or limited to property but includes also that part of any cost or expense incurred which is properly carried forward upon a closing of books at a given date. Consistently with the definition of balance sheet previously sug- gested, the term asset, as used in balance sheets, may be defined as follows: ' Something represented by a debit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting (provided such debit balance is not in effect a negative 1Ronello B. Lewis. Financial Analysis for Management (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1959). PP. 161-162. 76 EXHIBIT 16 Comparison of Similar Lease and Bond Provisions Lease Provision Comparable Bond Provision 1. Leasing is a source of capital. 2. Lease requires periodic pay- ments for a fixed period of time. These payments contain two ele- ments: (a) Return of investment. (b) Return (Tn investment. (Since the false is normally "net, " the return can be calcu- lated at a fixed rate in advance). 3. Leases often contain a "re- jectable offer" clause which en- ables the lessee to "retire“ the lease early. 4. The primary security behind the lease is normally the general credit of the lessee rather than the value of the leased property. 1. Bonds are a source of capital. 2. Bonds require periodic pay- ments for a fixed period of time. These payments contain two ele- ments: (a) Sinking fund payment or a serial maturity (return c_>_f in- vestment). (b) Periodic interest (return _o_r_1 investment). This return can also be calculated at a fixed rate in advance. 3. Bonds often contain a "call" provision which gives the borrow- er the right to retire them prior to maturity. 4. The primary security behind a bond issue is also the general credit standing of the borrower. Mortgaged or pledged property is only of secondary importance. 77 balance applicable to a liability), on the basis that it represents either a property right or is properly applic- able to the future. Thus, plant, accounts receivable, inventory, and a deferred charge are all assets in balance-sheet classification. The last named is not an asset in the popular sense, but if it may be carried forward as a proper charge against future income, then in an accounting sense, and particularly in a balance-sheet classi- fication, is an asset.1 As with other assets, the "rights to use of leased property" is recorded at cost. In the case of a lease, "cost" represents the total rental payments over the life of the asset less the implicit interest con- tained therein, i. e. , the payments made for the right to use the property without regard to charges which are associated with the method of financing the acquisition of this right. In the case of a sale-and-lease- back agreement, "cost" is the total amount paid to construct the asset itself. In other cases, "cost“ is equal to the cash price of the asset. Such a practice is identical to the treatment which would be given the asset if it were purchased from funds supplied by a more conventional form of financing and is in complete harmony with the fundamental con- cept of cost. Likewise, including the account "rental obligations under long- _ term leases" as a liability would seem to fit the definition of the term "liability. " The American Institute of Certified Public Accountants' Committee on Terminology has given the following definition: Similarly, in relation to a balance sheet, liability may be defined as follows: Something represented by a credit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset.‘ Thus the word is used 1American Institute of Certified Public Accountants, Accounting Research and Terminology Bulletins, p. 13. 78 broadly to comprise not only items which constitute liabilities in the popular sense of debts or obligations (including provision for those that are unascertained), but also credit balances to be accounted for which do not involve the debtor and creditor relation. For ex- ample, capital stock and related or similar elements or proprietorship are balance-sheet liabilities in that they represent balances to be accounted for, though these are not liabilities in the ordinary sense of debts owed to legal creditors. 1 4.. The advocates of capitalization feel that the financial statements would be more meaningful if the assets and liabilities arising from lease agreements were included therein. By reflecting these financial ‘5 facts in the books of account, the financial statements would become more useful to the analyst. The need for such a revision is made clear in the following statement by a partner of a large investment dealer: Unfortunately, lease liabilities are not found in the capital structure as stated on the books, and this is a serious shortcoming of present-day balance sheets. But every compe- tent analyst and every creditor or potential creditor knows that leaseholds belong on the asset side of the balance sheet and lease liabilities belong on the liability side, and in appraisal these balance sheet adjustments are entered mentally. Certainly no banker or potential lender would be willing to appraise the statements in any other light. So, in reality, money provided by an owner-landlord under a lease or leaseback is an essential part of capital and should be so regarded in true analysis.2 In evaluating the financial statements of lessee companies, banks have similar need to adjust the financial statements presented by the accountant as indicated by the following statement from a bank official: Although a lease arrangement eliminates from the balance sheet a liability for borrowed money, there still exists an obli- gation to make payments in the future. It seems necessary, therefore, to adjust the balance sheet of the seller-lessee so as to reflect the true liability attaching to such leases, because from llbid., pp. 13-14. ZLewis, pp. c_i_t., p. 162. 79 a statistical and a practical viewpoint there is very little difa ference between a lease arrangement and a term contract involving borrowed money. In either case the failure to service the obligation results in loss to the debtor of the use of the property involved. 1 Donald R. Gant, a member of the investment banking firm of Goldman, Sachs and Company, expressed similar views in the article from which we quoted earlier in this chapter. The capitalization technique described in this chapter should overcome the shortcoming in present-day balance sheets described by Lewis, Booker and Gant and thereby eliminate the analysts' need for making adjustments to the financial statements mentally. The Capitalization Controve r sy The proposal to capitalize long-term leases has received mixed reactions from the financial world. Both the case against, as well as the case for, capitalization are considered in the following paragraphs. The Case Against Capitalization The capitalization proposal has been met by some rather violent opposition. In a letter to the editor of The Journal of Accountancy, the president of a leasing company made the following statement: . . [Capitalization] seeks a departure which strikes at the very foundation of accounting, a foundation based on the fundamental concept of cost. Once this concept is breached, there are no reaches of the wild blue yonder into which accounting improprieties may not treSpass--to the disadvantage of all segments of the public.2 1Claude H. Booker, Jr. , "The Leasing Arrangement, " Robert Morris Associates Bulletin, Vol..XLIII (October, 1960), p. 30. zAlvin Zises, "Recording Leases Obligations, " letter to the editor of The Journal of Accountancy, Vol. CXI (June, 1961), p. 28. 80 Zises supported this position against capitalization by citing the following statements of bankers, insurance executives and financial analysts: The thing that disturbs me about that [capitalization] is the bringing into the financial statements of . . . artificial assets or liabilities which cause distortion and make analysis quite difficult.1 . the investor and the lender in analyzing a financial statement wants facts not conclusions of the accountant. 7‘ The capitalization of leases logically would dictate the inclusion of the current position [sic] of them in current assets and current liabilities. . . . Would we not compound a serious problem for many corporations which in their loan agreements may have a provision requiring the maintenance of a certain relationship between current assets and current liabilities ? The corporation in question may become a technical violator of the loan agreement.3 The inclusion of these amounts in the balance sheet could present considerable difficulties from the viewpoint of uniformity of approach and they may tend to distort the financial picture from the viewpoint of review by many of the relatively less in- formed lenders and investors.4 I can imagine nothing much more chaotic than for the CPAs to take the position in favor of capitalization and the security analysts, the income account approach and tabulation of commitments. 5 1A statement by "a senior officer of one of the largest banks in Michigan" as quoted by Alvin Zises. Ibid. ‘ 2A statement by "the president of one of the largest banks in the South" as quoted by Alvin Zises. Ibid. 3A statement by "the first vice president-investments of a large insurance company in New England" as quoted by Alvin Zises. , Ibid. 4A statement by "the vice president of one of the largest banks in the Southeast" as quoted by Alvin Zises, Ibid. , pp. 28-29. 5A statement by a "financial analyst" as quoted by Alvin Zises. Ibid., p. 29. 81 . . it is clear, at least in my mind, that leasing and debt are two different things. Anything which is done to make these types of financing appear one and the same is mislead- ing and this applies to accounting treatment, legal treatment, tax, etc.1 The position against capitalization was supported by other letters to the editor in which the following comments were made: I believe that those who advocate the capitalization of long-term leases are trying to transform the balance sheet into a crystal ball. Even if it were desirable to do so, which it is not, I find it hard to believe that a reasonable formula can be divised to reduce to a common basis of dollars and cents the diverse factors involved in the infinite variety of lease terms and relationships . 2 As one long concerned with lease problems from the points of view of leading institutions, lessors and lessees, I have uni- formly and steadfastly supported all who stand for full disclosure. I feel, however, all factors considered, that the proper place for such disclosure is in a footnote and not in the balance sheet as such. _ I fear misleading implications of sale, rather than lease, if the transaction is handled otherwise. No sophisticated analyst will be misled by a properly worded footnote.3 These attacks against capitalization may be summarized as follows: 1. Legal differences between the lease and the more conventional forms of debt. These were discussed in greater detail at the end of Chapter III. 2. The inexactness of capitalization techniques, the wide margin of error and the drastic effect these errors would have on financial analysis . xA statement by ”an officer of one of the largest New York City banks, " as quoted by Alvin Zises. Ibid. 2Donald C. . Cook, "Long-Term Leases, " letter to the editor of The Journal of Accountancy, Vol. CXI (May, 1961), p. 33. 3'Lester E. Denonn, "Long-Term Leases, " letter to the editor of The Journal of Accountaniy, Vol. CXI (May, 1961), p. 34. 82 3. The hardship that capitalization would work on many firms who are now engaged in leasing (e. g. , it would cause many firms technically to violate their loan agreements). The Case for Capitalization A major change in accounting procedures, such as has been sug- gested here, can presumably come about only if it can overcome the wrath of those who are employing the obsolete practice. For this reason, the arguments which have been presented against the proposal must be examined more closely. Legal Arguments Much of the case against capitalization is centered around the legal arguments which were presented in Chapter III as the rationale underlying current reporting. The three major legal arguments pre- sented were: first, the lessee does not hold legal title to the leased property; second, other contractual items, such as purchase commit- ments, are treated in the same manner as are leases; and third, the differences between the lease and the more conventional forms of debt in the event of financial difficulty. Lessee does not hold legal title. --The fact that the lessee does not hold legal title to the leased property does not mean that the lease transaction should be excluded from the lessee's books. The concept of looking beyond the legal details of a transaction to the broader financial facts has been used in other areas of accounting for decades. For example, when a firm acquires the use of an asset under a con- ditional sales contract, it does not have legal title to the asset until the debt has been completely paid. Few accountants would hesitate to include this under the assets of the using firm. In fact, anyone who 83 would suggest otherwise would be charged with presenting incomplete and misleading financial statements. Similar treatment of other contractual items. --One basic objection to the capitalization of leases which was expressed in the previous section was concerned with the fear that it may open the door to pulling other contractual items onto the balance sheet. It is conceded that capitalization may indeed open the door to other changes in the financial statements. It does not necessarily follow, however, that all other con- tractual obligations and commitments will eventually find their way onto the balance sheet. It is important to note here the distinction between a financial lease and a service lease as it was discussed in Chapter II. In this connection, it was proposed only that the financial lease be capi- talized. Similar reasoning should be applied to other contractual obli- gations, such as long-term purchase commitments or labor contracts. To the extent that one party has performed his obligation under the con- tract, the second party has acquired an asset. To the extent that these services have not been paid for, he has incurred a liability. In the case of a financial lease, one party (has performed all or essentially all of the service required of him without receiving payment therefor; and for this reason it is held that the other party has acquired an asset and incurred a liability. So it should be with any other contractual obligation. If one party agrees to deliver merchandise at a fixed' price at some future date, and the other party agrees to purchase the merchandise under these same terms, there exists a contract but no liability. As soon as one of the parties performs on the contract (party one delivers the goods or party two makes payment therefor) the other party acquires anasset. To the extent that one party has performed and the other has not, the latter party has incurred a liability. 84 Differences in the event of financial difficulty. --The opponents of capitalization point to the different treatment which is given leases in the event of financial difficulty, as opposed to the treatment given debt instruments in the same conditions, as a major reason for not reCOgnizing leases on the balance sheet. In this connection, it should be noted that the accounting profession has long recognized the principle of the "going concern. " Under this concept, the financial statements are prepared under the assumption that the firm will continue in business for an indefinite period of time. If this assumption is not valid, then it is likely that neither the assets nor the liabilities will be realized at the figure at which they are shown on the balance sheet. The fact that their book value may be more or less than their liquidation value does not cause us to omit these items from the balance sheet entirely. Why then should the fact that in the event of financial difficulty our lease liabilities will not be paid at book value cause us to treat them any dif- ferently? From the standpoint of the "going concern, " the lease asset and lease liability both belong on the balance sheet. Should the company encounter serious financial difficulty, the accountant would abandon the conventional statements and prepare a statement of realization and liquidation. In this instance, it would be appropriate to show the lease obligation at the figure at which it is anti- cipated it will be paid (between one and three years rental) rather than omitting it from the statement entirely and referring to it in a footnote only. The conventional balance sheet, however, would be prepared in accordance with the “going concern" principle; and, accordingly, any arguments based upon differences in the case of bankruptcy would not be va lid. Legal vs. financial accounting. --All of the arguments against capitalization which are based on legal grounds are weakened by the faCt that they ignore important financial and economic facts. They fail 85 to recognize the financial similarities between the lease and the more conventional forms of debt and accordingly use faulty reasoning to justify their position. For example, in the letter cited in Chapter 111, Richard Sanzo, senior editor of Dun and Bradstreet, Inc. , argued against capitalization on the basis that ”. . . a lease obligation would be liqui- dated in fact out of income and not out of assets. " Yet this same author, in pointing out the dangers of excessive debt financing, made the follow- ing statement: When money is borrowed to put into fixed assets, the borrowings become a kind of mortgage on future earnings or new capital. For only earnings or new capital can repay that kind of debt. Meanwhile, maturing debt instalments may become trouble- 3 ome [emphasis supplied]. 1 This latter statement makes it clear that conventional debt incurred to finance fixed assets is also typically repaid out of "income and not out of assets. "2 According to Sanzo's reasoning, almost all liabilities of a growing company should be omitted from the balance sheet, since both the company and the creditors look to the earnings rather than to present assets for repayment. Obviously, just the reverse is true. Because both leases and conventional long-term debt “become a kind of mortgage on future earnings, " they both belong on the balance sheet. Inexactness of Capitalization Techniques The fact that a figure must be estimated is no reason for ignoring it. Accounting is full of estimates, and a carefully made estimate is certainly more valuable than none at all. The accountant, therefore, is justified in placing figures on the balance sheet which represent mere approximations. However, the fact is that the capitalization technique lRichard Sanzo,. Ratio Analysis for Small Business (Washington, D. C.: Small Business Administration, 1960), p. 52. 7‘1 am using Sanzo's words here. Actually, it might be more correct to Say that both lease obligations and debt obligations are typically met 011‘: Of assets which are provided from earnings inasmuch as earnings (or incOn'ie) merely represent asset increases. 86 suggested earlier in this chapter is actually more exacting than tech- niques utilized by the accountant in many other areas. The charge of inexactness possibly stems from the fact that the word "capitalization" has been used to refer to at least two very different techniques. The first technique, and the one used here, calls for discounting the future rentals payable under the lease to their present value at the interest rate implied in the lease agreement. This is a very exact process and is no more difficult than amortizing a premium or a discount on bonds over the life of the issue. The second technique, also described by some writers as capitali- zation, is much less precise. It involves some very important assump- tions and does not make use of the "present value" concept. Donald R. Gant describes this second technique, together with some of its limi- tations, as follows: The more sophisticated approach, which is being adopted to an increasing extent, represents an attempt to recast a com-:- pany's balance sheet to include the assets and the liabilities which its lease commitments are believed to represent. This involves capitalizing its annual lease rentals at some arbitrary rate--commonly in the range of from 6% to 8%. The annual rental payments are in effect assumed to represent 6% or 8% of the unamortized investment in leased property. For example, a $1 million annual rental commitment, capitalized at a 6% rate (i. e. , $1 million divided by O. 06), would be assumed to repre- sent a $16. 7 million investment in leased assets, which would be added to the asset side of the balance sheet, and a similar long- term obligation, which would be added to the liability side. The capitalization rate used obviously has an important bearing on the results which this type of analysis will produce. The selection of a rate, in turn, involves an implicit assumption as to the average remaining term of the company's leases and the interest return to the investor which is incorporated in the rental payment. If this interest factor were 5%, for example, capitalization at 6% would assume an average remaining term of 36 years (this being the length of time required for a loan of $1 bearing interest at 5% to be repaid through annual payments of $0.06 each); an 8% capitalization rate, a 20-year remaining term 87 (this being the length of time required for the same $1 loan to be repaid through annual payments of $0. 08 each). These commonly used capitalization rates undoubtedly tend to overstate the liability represented by the lease commitments of most companies, since the average remaining term of their leases is probably less than 20 years.1 The argument that capitalization is a very inexact process which involves assumptions that may grossly overstate the liability represented by lease commitments is valid when referring to the process described by Gant. However, inasmuch as these estimates are not necessary under the "present value“ concept described earlier in the chapter, these arguments are not a valid criticism of the process described as "capitalization" in this study. Capitalization Would Impose Hardships It is quite possible that a major change in accounting procedures, such as the proposed capitalization of leases, may work a temporary hardship on some firms which enter into lease contracts prior to the time the change is made effective. However, because of the rapid rate at which leasing is growing, the longer the change is deferred, the greater this hardship will be. It is also felt that these hardships have been somewhat exaggerated. Banks are not in business to call loans or force bankruptcy at every possible opportunity, but instead to loan money. It seems unlikely that a prudent banker would call a loan merely because a change in the accounting procedures caused a technical violation of a loan agreement. Development of Capitalization The capitalization proposal was first made following the second lGant, _o_p_. git” p. 139. 88 world war at the time leasing was beginning to gain wide usage as a financing device. At that time some accountants were advocating extending to leasing the long established concept of looking beyond legal details to financial facts. Writing in The Accounting Review in 1948, Professor John Myers stated: The whole theory of consolidated balance sheets is based on looking through legal details to see the broader economic facts. I believe the same idea should be applied in recording the acquisition of a plant with the use of outside funds, i. e. , look through the legal details and record the broad economic facts of the case.1 Similar views were expressed at about the same time by Arthur M. Cannon in an article in The Journal of Accountancy. In this article Cannon examined the published financial statements of Safeway Stores, Inc. , Allied Stores Corporation, Montgomery Ward and Company, and J. C. Penney Company and made the following observations: Rapid expansion of so-called "buy-build-sell-lease" pro- grams of major retailers divests their balance-sheets of important fixed assets and long-term fixed obligations. Do statements "fairly present the position" of these companies ? What both the owner and mortgagee rely upon is the long- term non-cancellable promise to pay of the tenant. But no hint of a credit balance appears in any liability account in the tenant's books. One wonders if credit is the kind of cake you can eat and have, too. It is not yet accepted accounting practice to mention in published audit reports the existence of long-term non-cancellable net leases, nor is attention generally directed to the possible contingent liabilities connected therewith. The published audit reports for 1946 on the four companies previously mentioned in greatest detail make no such mention. One answer might be to show the leasehold as a fixed asset subject to amortization, and the rent obligation as a fixed liability. . In the meantime and pending a more satisfactory device, we 1John H. Myers, "Presentation of Long-Term Lease Liabilities and the Balance Sheet, " The Accounting Review, Vol. XXIII (July, 1948), p. 291. ~ 89 may fall back on the overworked stratagem of the footnote to set out the facts as to these fixed obligations unrelated to any present balance-sheet fixed asset or funded debt. This would seem to be the minimum duty if our statements are to "fairly present" the real financial condition of audited companies.x To a large degree, the profession has followed Cannon's sug- gestion and has fallen back on the footnote in an attempt to present fairly the financial position of lessee companies. This practice has continued as accountants have failed to reach agreement on a "more satisfactory device. " The advocates of capitalization, however, maintain that a "more satisfactory device” has now been developed and the "meantime“ is now over. This controversy stimulated a series of rather heated magazine articles. One of the most interesting series was presented in the Harvard Business Review and started with an article by Donald Gant which appeared in the March—April 1959 issue.z His article provoked many letters to the editor in which Alvin Zises, the president of a leas- ing company, led the crusade against capitalization. Zises then pro- ceeded to initiate a similar controversy in the February 1961 issue of The Journal of Accountancy.3 And so the smoke began to rise as the fire spread to many other publications. In response to the great interest which was aroused by the Gant article, the editors of the Harvard Business Review asked Richard F. Vancil and Robert N. Anthony to explore certain aspects of the contro- versy. Through direct-mail surveys, they contacted. some 512 financial institutions, as well as l, 310 of the largest industrial, merchandising, 1Arthur M. Cannon, "Danger Signals to Accountants in Net Lease Financing, " The Journal of Accountancy, Vol- LXXXV (April, 1948), pp. 312-319. zGant, op. cit. 3'Alvin Zises, "Disclosure of Long-Term Leases, " The Journal of Accountancy, Vol. CXI (February, 1961), pp. 37-47. 90 utility, and transportation companies in the United States. Their find- ings were reported in the November-December 1959 issue of the Harvard Business Review and are summarized in the following para- graphs. 1 In regard to the financial institutions, Vancil and Anthony were interested in determining if these institutions had formal techniques for weighing lease obligations for credit purposes. They summarized their findings as follows: (1) A majority of the analysts in each type of institution sur- veyed state that they use one or both of the formal analytical techniques. The smaller figures from the more detailed second- stage survey suggest that in the first-stage survey many respond- ents had given us the answer they thought we were looking for rather than the answer applicable to their situation. This difference between the first-stage and second-stage surveys might also be interpreted as meaning that analysts in many institutions think that some formal technique is desirable or appropriate, but only a few institutions have actually established the use of a formal procedure on a routine basis. (2) Only a very few mutual funds, investment banks, pension and college fund trustees, and rating companies actually use formal analytical techniques in evaluating lease obligations. (3) A significant number of insurance companies and com- mercial banks do use such techniques. [Exhibit 17] shows the numbers of users stated as a percentage of the original mailing, with adjustments for the estimated practices of nonrespondents as well as those who answered the second-stage survey in a different manner than they answered the first-stage survey. (4) Only a few insurance company and bank analysts are using capitalization procedures which result in a reasonably accurate estimate of the equivalent liability represented by a lease obligation. 2 In the corporate survey, Vancil and Anthony attempted to "observe the incidence and effectiveness of restrictions against leasing in 113 corporate loan agreements. They were led to conclude: 1Richard F. Vancil and Robert N. Anthony, "The Financial Commun- ity Looks at Leasing, " Harvard Business Review, Vol- XXXVII (November- December, 1959). PP. 113-130. 2Ibid., p. 118. 3Ibid., p. 121. 91 .12 .Q gamma .uonaooofltuo£80>ozv HH>XX 40> .Bogom mmocfimsm puma/Emma : .wgmmod be $304 3358800 Hmwocmcflh 03H... Scoficaoa .Z phenom pad Socm> ..m pumflofima .mofianmcHoo oosmudmcw acopcommoucoc 2 use 9303 ucopcommousoc w mo >0>adm 0:02.333 0 so comma. muqopcommonco: :0 mo mcofiod poumcfiumo be: 0350:“ On #0305300 Goon. were: wouflmfimc m v m m mm 2 OH swig: ououdoom 30.20909. 58:? mfismea cospoum 3 mo £03m wcwon. 03.3qu flogged.” 05 mo 3me 05 CO mm 2 2 am S mm ..>..an omeoo upcooem on noncommon .3. 00303:: m< mm. a: 3 me em mm .858 omooo tumafl 0o. momcommon c3. 030035 m4 "#3330: .m me 3:08de 0003 0233an 2. NM mm mm on mm r858 omooo upcooom on momcommou >3 “03006:“ m4 seem ea; me a? sac... 2. >868 omoao tumufl op noncommou >0. 0030233 m4 ”omumfio poxfl mm managing modem ”.0pr 923.05 waging ounpvoonm 9:205 malice unapoooum endpooonm Hmcfimwao Hmsfimio wcflmd Hecwwwno Hmcwwio mains mo “coo Mom mo “coo Mom MoQESZ m0 300 hem mo «Goo Honm Hones/H mm muommxw m0 muomm< mxcmo, 33.88500 mowsdmaoo oocdusmcH amended SnoHtmsod wcfinwswooom no“ betwoacsm one monscoooum Hmanoh £033 00 ucouxm popmfiflmm NA BHMHEXM 92 (l) The use of lease financing is relatively common in American industry. Nearly 50% of the industrial corporations surveyed are parties to long—term leases, and this percentage rises to 88% for retail and wholesale merchandising concerns and to 93% for integrated oil companies. The number of com- panies engaged in long-term leasing appears to increase as the percentage of debt in the capital structure increases. (2) Less than 50% of the respondents (other than utilities) that have loan agreements restricting or limiting the incurrence of additional long-term debt also have effective restrictions con- cerning the incurrence of additional long-term lease obligations. The most common effective restriction, found in about two thirds of the cases of effective restrictions, is one which limits the total payments under long—term leases to a certain dollar amount each 0 year. (3) Restrictions against long-term leasing almost always apply to real estate, but in over 50% of the cases a restriction is also applicable to equipment and other chattels.1 The Vancil-Anthony study provides evidence that most analysts recognize the lease as a form of debt. Many of them have accordingly established formal procedures to revise the financial statements as presented by the accountant in order to properly reflect the lease transaction. Others presumablythln} that such procedures are desirable but for some reason have not established them.2 This would seem to indicate that from the standpoint of the financial institutions, the state- ments of lessee corporations as prepared by the accounting profession are not adequate. While most of the analysts recognize this inadequacy, they have apparently not been able to establish procedures which compen- sate for this deficiency. This is evidenced by the replies to a case situation prepared by Vancil and Anthony in which each respondent ". . . was asked to indicate the amount of the adjustments, if any, he would actually make [to the financial statements] if he were analyzing 1Ibid., pp. 124-125. ZIbid., p. 118. 93 1 . Their results were as the company for credit appraisal purposes. " follows: . of the 41 respondents, 11 reported an amount of capitalized rent within the reasonable range established, but 14 reported a greater amount, and 16 reported a smaller amount/7’ This means that only 25 per cent of those attempting to adjust the financial statements were able to arrive at an amount which reasonably approximated the equivalent debt. The authors reported that ”. some very large institutions are included among those above and below the acceptable limits. "3 These figures seem to indicate a need for the professional accountant to assume the responsibility for seeing that the leases have been properly capitalized-r-first of all, because the institu- tional reader has indicated that conventional financial statements are not adequate for his purposes; and second, because the financial analysts have demonstrated that they are unable to come up with a reasonable figure in many instances. Textbook Treatment Unfortunately, the capitalization proposal has not been given adequate consideration in accounting and auditing textbooks. Moonitz and Staehling present a very good but limited discussion of the subject in their book, Accounting--An Analysis of Its Problems, and take a position favoring capitalization.‘ However, most textbooks ignore the 1Ibid., p. 117. 2M , p. 12.0. The "reasonable range" was established "by dis- counting the future lease payments to their present value using as the interest assumptions 6% compounded monthly for the low figure and 5% compounded annually for the high figure--the two most extreme assump- tions stated by the 11 respondents who used this technique. " (told. , p. 119). 31bid., p. 120. 4Maurice Moonitz and Charles C. Staehling, Accounting--An Analy- sis of Its Problems, V01. 1, (Brooklyn, New York: The Foundation Press, 1952), pp. 312-325. 94 problem, and many do not even refer to leases or leaseholds in the When they do mention them, they usually provide no discussion of capitalization or the problems generated by the financial lease. For example, Holmes, in his Auditing: Principles and Procedure, suggests the following audit program for leaseholds: Examine leasehold authorization. Examine leasehold agreements or contracts. Ascertain that leases are properly valued at amortized cost. Verify cost and amortization if advance payments have been made. 5. Verify the cost and amortization of leasehold improvements. QUONH 1 In elaborating on this program, Holmes states: In recent years, there has been a growing practice of using long-term leases as a method of financing. . . . It is the opinion of the author that adequate disclosure should be granted the exist- ence of such long-term leases in the financial statements, in accordance with Accounting Research Bulletin 43, chapter 14. Leases should not appear as assets unless (I) a flat amount has been paid in advance to cover the leasehold or (2) the original lessee has capitalized his expected savings or profit derived or to be derived under a sublease; this is not customary.2 Bell and Johns in their book Auditing recognize the problem but fail to deal with it when they state: The growth of such practices [sale and leaseback] has created problems of disclosure in financial statements. When the rental or other obligations under long-term leases are material, good practice requires disclosure be made by way of footnotes to the financial statements or otherwise as to the aggre- gate amount of the required annual rentals and other pertinent facts.3 1Arthur W. Holmes, Auditig: Principles and Procedure (5th ed.; Homewood, Illinois: Richard D. Irwin, Inc., 1959), p. 559. 21bid.. pp. 559-560. 3William H. Bell and Ralph 5. Johns, Auditing (New York: Prentice-Hall, Inc., 1952), p. 272. CHAPTER V METHODOLOGY Selection of Companies In order to evaluate the impact of capitalization on financial ratios, it was first necessary to select some actual cases for analysis. The initial task was to locate some companies that used the lease as a financing device. A logical starting point seemed to be those corporations which made some reference to leases in their financial statements, as reported in Accounting Trends and Techniques. Of the 216 companies which reported leases in one form or another, only 38 were identified in the thirteenth edition of this publication. These 38 were cited as examples of companies which reported various pro- visions of their lease agreements, such as annual rental, aggregate rental, lease expiration date, number of leases, renewal option, sale- and-lease-back feature, and term of lease. Six more lessee com- panies were added to the list from various sources. The list of 44 lessee corporations used in the study is included as Appendix 1. Having located some lessee corporations, the next step was to obtain information concerning their leases. In this connection, a request for a copy of the firm's most recent annual report was addressed to the controller or chief financial officer of each lessee corporation. Replies were received from all but two of the firms. Each annual report was then examined to determine the extent and nature of the disclosure of the long-term lease agreements. As indicated in Chapter 111, most of the companies confined their reporting on this subject to very brief footnote remarks which were typically not sufficient for the purpose of this study. 95 96 The next step was to search the files of the Securities and Exchange Commission to see if additional lease details were reported on the forms 10K filed with that agency. An examination was made of the forms 10K of 24 companies.1 In most instances, the forms 10K con- tained essentially the same information as that disclosed in the published annual report. Two companies, F. W. Woolworth and Allied Stores, provided substantially more detail. For example, F. W. Woolworth made the following comment in their annual report: Minimum annual rentals for leased property, excluding rentals based on a percentage of sales and excluding payments of real estate taxes or other expenses, total approximately $44, 300, 000, the major portion of which relates to leases expir- ing subsequent to 1965.2 In the form 10K, the company provided the following information: The aggregate of minimum annual rentals payable in subse- quent years, excluding rentals based on a percentage of sales and excluding payments of real estate taxes, insurance and other expenses, was $44, 269, 932 under 2, 639 leases in effect at December 31, 1960. The minimum annual rentals under such leases and periods of expiration are as follows: Lease Expiring: Annual Rentals 1959-1963 $ 5,393,752 1964-1968 3,418,472 1969-1978 15, 364, 998 1979-1988 6,124, 396 1989-1998 4, 775, 933 Subsequent to 1998 1, 353, 081 $36,430, 632 In addition, there are in effect 72 leases, with rentals based on a percentage of sales, without a minimum annual rental.3 1The forms 10K for the remaining companies were not available in the Chicago Office either because they were unlisted companies and were not required to report to the Securities and Exchange Commission or else were listed on the Mid-West Stock Exchange. The Chicago office of the Securities and Exchange Commission reported that the forms 10K for this latter group had been transferred to the office of the Mid-West Stock Exchange. 2F. W. Woolworth Company, Annual Report, December 31, 1960. 3F. W. Woolworth Company, Form 10K, in the files of the Chicago Regional Office, United States Securities and Exchange Commission. 97 Even the above information is not detailed enough to enable the reader to capitalize the leases accurately. This lack of sufficient detail placed at least two important limitations on the study. To begin with, it made it impractical to select scientifically a sample because so few firms disclosed sufficient detail to permit even a reasonable esti- mate to be made of the capitalized value of their leases. For this reason, it was concluded that this thesis must be confined to a pilot study of some actual lease cases. Any attempt to estimate the over-all impact of capitalization of leases based upon sampling techniques must, of necessity, be deferred until reporting becomes more extensive. The second limitation was imposed by the fact that none of the companies provided all of the details required for precise computations.1 This reduced the possible scope of the study by introducing certain assumptions and estimates into the calculations. For example, in only one instance was the exact lease expiration date shown. 2 In all other cases, the reader was told only that a large number of leases were to expire ”sometime" within a specified period of time (usually five to ten years). Likewise, the annual rentals payable under each individual lease were often buried in aggregate figures. . Even more significant, however, was the omission of the interest rate implicit in each of the lease agreements. None of the companies gave any indication of this implied interest rate in either its annual report or in its form 10K. Because of this insufficient data, only eleven of the forty-four companies studied were selected for capitalization. Six of the companies disclosed enough information in their annual reports to enable the reader 1Textron, Inc. , did show the discounted amount of rentals payable under leases in a footnote to the financial statements but did not provide any details as to how this amount was arrived at. ZPurolator Products , Inc . 98 to arrive at a reasonable estimate of the equivalent amount of debt represented by the lease obligations. The information for the other five was obtained from the examination of the forms 10K. Determination of Rental Schedules Inasmuch as rental payment dates were not specified, it was next necessary to make some assumptions in this regard. To begin with, it was assumed that all lease rentals were payable annually as of the last day of the lessee's fiscal year. In those cases where lease expira- tion dates were not specified but where a number of leases were designated as expiring within a certain period of time, all leases in that group were assumed to expire exactly mid-way through the period. In the case of a tens-year period, for example, it was assumed that the leases expired at the end of the fifth year. Where a five-year period was used, the leases were assumed to expire mid-way through the third fiscal year. In those instances where this assumption resulted in a lease expiring half-way through a year, the total rent payable during that year was calculated as one-half the amount payable during the pre- ceding year, plus one-half the amount payable during the subsequent year. Where the time period specified had an open end (for example, "1976 and thereafter") it was assumed that all leases in this period expired as of the end of the £ir__s_t_ year in the open- end period. This treatment was justified on two grounds. First of all, such an assump- tion was conservative, and it appeared more desirable to understate the discounted value of the leases rather than run the risk of over- statement. Second, it was felt that in recognizing the time value of money, the rentals payable during this open-end would be insignificant in relation to the discounted value of the rentals of the earlier periods. 99 The rentals payable during the periods of renewal or the fair market value of the property at the end of the initial period (whichever was applicable in the circumstances) should also have been discounted to their present value. However, the details necessary for making these calculations were not available and so these amounts were ignored. Once again, the time value of money would make these amounts appear relatively insignificant. The techniques used to estimate the amount of rentals payable each year may be seen by referring to the case of Peoples Drug Store.1 The form 10K filed with the Securities and Exchange Commission for the year ended December 31, 1960, disclosed the following information: Number of Aggregate Minimum Years Expiration Leases Annual Rental 1961 to 1965 inclusive 63 $ 555, 314 1966 to 1970 inclusive 45 397, 880 1971 to 1975 inclusive 30 394, 756 1976 and thereafter 56 1,133, 250 194 $2,481,200 Using the technique described previously, it was assumed that the 63 leases in the first period were scheduled to expire June 30, 1963; the 45 in the second period were scheduled to expire June 30, 1968; the 30 in the third period were scheduled to expire June 30, 1973; and the 56 in the final period were scheduled to expire December 31, 1976. Based upon these assumptions, the following schedule of rent payments was drawn up: 1Schedules of Lease Rentals for the eleven companies used in the study are included as Appendix II. 100 Date Amount (December 31) of Rent 1961 $2,481,200 1962 2,481,200 1963 2,203,5431 1964 1, 925, 886 1965 1,925,886 1966 1, 925, 886 1967 1,925,886 1968 1,726,9462 1969 1,528,006 1970 1,528,006 1971 1,528,006 1972 1,528,006 1973 1,330,6283 1974 1,133,250 1975 1,133,250 1976 1,133,250 Selection of Interest Rates Having estimated the annual rentals for each firm, it was next necessary to arrive at an appropriate rate of interest in order to com- pute the present value of the future rentals. Because there were in excess of 5, 750 leases involving eleven different companies and nego— tiated over a period of ten or twenty years, no one interest rate could possibly apply to these varied circumstances. On the other hand, be- cause none of the eleven companies specified the interest rate implicit in its lease agreements nor provided sufficient detail to compute these implied rates, it was impractical to attempt to estimate the individual rates for each of these 5, 750 leases. For this reason, it was necessary to arrive at one rate which could be used in capitalizing the leases in- cluded in this study. 1One-half 1962 rent ($1, 240, 600) plus one-half 1964 rent ($962, 943). ZOne-half 1967 rent ($962, 943) plus one-half 1965 rent ($764, 003). sOne-half 1972 rent ($764,003) plus one-half 1974 rent ($566,625). 101 The interest rate selected for the calculations was six per cent compounded annually. The selection was based on a number of con- siderations. To begin with, reference was made to the coupon rate at which the eleven companies were borrowing long-term funds. Two of the firms did not indicate the rate of interest available for borrowing, but the other nine indicated rates which varied from three to six per cent. The rate selected for capitalization, then, approximated the high- est rate of interest paid by any of the firms for borrowed funds. The six per cent rate was no doubt higher than the average rate for borrowed funds. However, this was justified on two grounds. First of all, it is rather uniformly agreed that the rate of interest is typically higher under a long-term lease than it would be under borrowing by the same firm. In regard to the interest rates charged by his firm, the vice-president of a large mortgage banking firm wrote: The typical interest rate under a leaseback for a company of modest means, which in our terminology would mean between $1, 000, 000 and $4, 000, 000 net worth, would carry a rate of at least 6% plus amortization over the primary lease term. It is exceedingly difficult to say that any rate is typical due to the credit standings of different companies. While one com- pany of $4,000, 000 net worth might be up to their ears in long- term debt and require a rate of 6%% plus amortization, another of equal worth might be entirely free of long-term debt with tre- mendous earning capacity and require a rate of 5-3/4% plus amorti- zation. The rates on all purchase-leasebacks are higher than either first mortgage loans or private placements, due to two factors: The first is the tax situation of the various insurance company investors, and the second the added risk of 100% equity in a parcel of property. During this current year we have made leasebacks as low as 5% plus amortization with the highest being 7% plus amortization. In the first instance, the company had a net worth in excess of $75 million, and in the last, the company was a trucking concern, with a net worth of approximately $3. 5 million. 102 To be specific, we would say that the rates on purchase- leasebacks would average from one-quarter to three-quarters of a per cent higher than the rate demanded on either a first mortgage loan or a private placement loan. Here again, we have to insert that credit would be a determining factor. The market, as we previously stated, for purchase-leasebacks among insurance company investors has narrowed considerably during the past 18 months. In their place we have been negotiating purchase-leaseback arrangements with Pension Funds, State Retirement Funds, Fraternal organizations, Union Funds, all of whom are more interested in this type of financing due to the fact that they are tax exempt.1 Other authorities cite figures which are comparable. Donald R. Gant states "this differential [between leasing and borrowing] is usually in the range of%- of 1% to 1%, but may often be greater. ..2 Referring to the interest rate to be charged on automobile and equipment leases, Keith G. Cone, Vice President of the La Salle National Bank of Chicago, states ". . . the rock bottom rate should be 6% simple interest with a standard rate of 6%?- 7% without making anyone overly rich on financing. "3 Frederick R. H. Witherby, Associate Counsel, New England Mutual Life Insurance Company of Boston, states "as a general rule, a premium of i— to 1% over the rate for direct, long-term obligations of prime credits . is commanded by an investment in a leasing company. "4 These statements seem to support the position that interest rates under leasing are typically higher than those charged on borrowing by the same firm. lLetter from J. V. Paffhausen, Vice-President, A. H. Gruetzmacher 81 Co. , Mortgage Bankers, 39 S. La Salle Street, Chicago 3, Illinois, November 27, 1961. zGant, 22. 33., p. 126. 3'Keith G. Cone, "Is Leasing the Answer?" A talk given before the Installment Credit Section, Texas Bankers Association, Hotel Texas, Fort Worth, Texas, September 15, 1958. 4Frederick R. H. Witherby,. "Personal Property Lease Financing-- The Lender's Point of View, " Paper read before The Association of Life Insurance Counsel at The Greenbrier, White Sulphur Springs, West Virginia, May 8, 1961, p. 561. 103 The second justification for the six per cent rate is the fact that it results in a more conservative estimate of the total liability under the lease. The higher the rate of capitalization used, the lower the present value of future rentals. This means that while the six per cent figure may be attacked by advocates of leasing as being too high in relation to the rate charged on borrowing by these same firms, the rate will nevertheless result in a conservative estimate of the total lease liability. The impact which a rate selection error would have on the capitalized value of a lease may be estimated by referring to Exhibits 18 and 19. Exhibit 18 shows the present value of $10, 000 annual rental payable at the end of the year for various periods of time and at various rates of interest. This table indicates that the longer the period of time and the greater the spread between the true interest rate and the estimated interest rate, the greater will be the error. Note, for example, that under a five-year lease, the error would be relatively small ($1, 171) if the true rate of interest were six per cent but a five per cent rate were used in capitalization. The error would be much larger ($16, 077 as opposed to $1, 171) under a thirty-year lease. Note, also, that the higher the rate of interest, the lower the capitalized value. Exhibit 19 shows the percentage error under various periods of time and various interest rates. It assumes that the true interest rate is six per cent and indicates the percentage by which the capitalized value would be over- or understated if some other rates were used. For example, under a five-year lease, the error would be +2. 8 per cent if a five per cent interest rate were used and a -2. 7 per cent if a seven per cent rate were used. The error would be greatly amplified under a thirty-year lease where the errors would be +11. 7 per cent and -9. 8 per cent, respectively. FT‘ x.) 'J €21 104 EXHIBIT 18 Present Value of a Lease Calling for $10,000 Annual Rental for Periods and Interest Rates Indicated 2 Rate of Interest Length of Lease 4% 5% 6% 7% 8% 5 years $ 44,518 $ 43,295 $ 42,124. $ 41,002 $ 39,927 10 years 81,109 77, 217 73, 601 70, 236 67,101 15 years 111,184 103, 797 97,122 91, 079 85, 595 20 years 135, 903 124, 622 114, 699 105, 940 98,181 25 years 156,221 140,939 127,834 116,536 106,748 30 years 172,920 153,725 137,648 124,090 112,578 4; ”Annual rentals are assumed to be payable at the end of each year. EXHIBIT 19 Percentage Error Incurred by Selection of Improper Interest Rate)“ *3}: Rate of Interest Length of Lease 4% 5% 6% 7% 8% 5 years +5.7 +2.8 0 -2.7 -5.2 10 years +10.2 +4.9 0 -4.6 -8.8 15 years +14.5 +6.9 0 -6.2 -1l.9 20 years +18.5 +8.7 0 -7.6 -14.4 25 years +22.2 +10.3 0 -8.8 -16.5 30 years +25.6 +11.7 0 -9.8 -18.2 Assume a lease with $10, 000 annual rental payable at the end of each year for the number of years indicated. *2'.‘ The true rate of interest has been assumed to be 6%. The table indicates the degree of error which would be incurred if some rate other than the true rate were used to capitalize the lease. 105 Capitalization of Leas es Working under the assumptions previously outlined, the financial leases of the eleven companies were capitalized. The present value of the rentals payable during the initial non-cancellable term of the leases was considered a "fixed asset" and included in the revised balance sheets under the caption "rights to use of leased property, at discounted amount of related long-term rental obligations. " The lease rentals pay- able within one year were considered "current liabilities" and were shown in the balance sheets as "current lease rentals. "1 The present value of lease rentals payable during the initial non-cancellable term, less the rentals payable within one year, were treated as "long-term liabilities” under the heading "rental obligations under long-term leases (discounted at implicit interest rates). ” The only revision made to the income statements was a shift from "operating expenses" to "interest charges" of the interest implied by the lease agreements. This was computed by multiplying the present value of the leases by the implied interest rate (six per cent). The schedules of capitalized leases of the eleven firms are included as Appendix II. From these schedules the balance sheets (and selected income statement items) were reconstructed to reflect the capitalized leases. These reconstructed statements are compared with the pub- lished ones in Appendix III. The impact of this capitalization upon financial ratios will be analyzed in the following chapter. 1Since the lease rental contains both principal and interest ele- ments, it would probably be more correct to include as a current liability only the amount applicable to principal plus the amount of accrued interest at the balance sheet date. Inasmuch as the dates that rentals were due were not known for the leases in this study, it was not deemed feasible to separate the current rental into principal and interest elements and therefore the entire current rental was considered as a current liability. CHAPTER VI THE IMPACT OF CAPITALIZATION ON FINANCIAL RATIOS Financial analysis is an art requiring expert judgment and skill on the part of the analyst. Unfortunately there exists no mythical crystal ball into which the analyst can gaze and clearly watch the future unfold before his eyes. But in spite of this apparent handicap, financial analysis need not be a ”fly by the seat of your pants" proposition. There are certain tools to which the experienced analyst can wisely turn. Among these are a number of financial ratios or proportions which, if properly computed and utilized, can be most helpful.1 Ratios enable the analyst to center his attention upon important financial state- ment relationships. Financial ratios are normally computed directly from the com- pany's certified financial statements without any adjustments being made by the analyst. In the previous chapters it was suggested that certain leases be capitalized and that the resulting amounts be included in the company's financial statements. This proposal would, of course, affect the amounts from which the ratios are computed and in turn, the ratios themselves. The purpose of this chapter is to determine the impact that capitalization would have on conventional financial ratios. 1The word "ratio" is used here in a rather broad context to refer to the relationship between two financial statement figures regardless of the form in which that relationship is expressed. For example, some ”ratios" are expressed as percentages rather than in the mathematical ratio form. The form which is most commonly used in financial circles will be used throughout this chapter. 106 107 Limitations of Ratio 5 A word of caution about ratios in general seems in order at this point. Ratios must be used for what they are--financial tools. Too often they are looked upon as ends in themselves, rather than as the means to the end. No ratio may be regarded as good or bad 2315‘ It may be an indication that a firm is weak or strong, but it must never be taken as proof of either one. Ratios may be likened to rail- road signals. They tell the analyst to stop, look and listen. Because of the limitations of financial ratios and the uncertainties surrounding the general business climate, some analysts refuse to use ratios and instead rely solely on their own intuition. Like the rheumatism weather forecasters, these analysts disregard the available signs and gauge a company's financial position solely by a "feelin' in their bones. " The following statement relegates this "hunch” method to its proper place. A man may say, if he like, that the moon is made of green cheese: that is an hypothesis. But another man who has devoted a great deal of time and attention to the subject, and availed him- self of the most powerful telescopes and the results of the observ— ations of others, declares that in his opinion it is probably com- posed of materials very similar to those of which our own earth is made up: and that is also only an hypothesis. But I need not tell you that there is an enormous difference in the value of the two hypotheses. That one which is based on sound scientific knowledge is sure to have a corresponding value; and that which is a mere hasty random guess is likely to have little value. Every great step in our progress in discovering causes has been made in exactly the same way as that which I have detailed to you. . . It is in these matters as in the commonest affairs of practical life: the guess of the fool will be folly, while the guess of the wise man will contain wisdom. In all cases, you see that the value of the result depends on the patience and faithfulness with which the investigator applies to his hypothesis every possible kind of verification. . . . 1 1Thomas Henry Huxley as quoted by Roger E. Ballard and Allan A. Gilbert, "How to Quantify Decision-Making, " Business Horizons, Vol. I (Winter, 1958), p. 79. 108 So it is also with the task of financial analysis. The analyst is still working only with hypotheses to which he must apply every avail- able test. While ratios may never transform an hypothesis to a fact, they may well distinguish the “fool" from the "wise man. " Granted that ratios have certain weaknesses but if the limitations are properly discounted, ratio analysis can be a most useful tool. There will likely never be a substitute for skilled judgment in the field of financial analy- sis. Nevertheless, the successful analyst will continue to utilize every available tool in exercising his judgment. Selection of Ratios The number of financial ratios possible is almost limitless. The only ones which are applicable to this study, however, are those which would be affected by capitalization. In Chapter V, it was noted the ”fixed assets, " "current liabilities, " "long—term liabilities, " and "interest charges" were all increased, while ”operating expenses" were decreased by capitalizing long-term leases. All ratios which utilize any of these items will consequently be affected. Some of the ratios affected by capitalization are: Current assets to current debt (current ratio)*T Net profits on net working capital>i< Net sales to net working capital (working capital turnover)*T Fixed assets to tangible net worth*T Current debt to tangible net worth*1’ Total debt to tangible net worth (debt to equity ratio)*T Inventory to net working capitali< Current debt to inventory* Funded debts to net working capital=1< Funded debt to net plant Debt to total capital ¥This ratio is included in 14 Important Ratios in 72 Lines of Business (New York: Dun and Bradstreet, Inc. , 1961). This ratio is included in the list of nine ratios suggested as key ones for small business purposes by Richard Sanzo, Ratio Analysis for Small Business (Washington, D.C.: Small Business Administration, 1960). 109 Net working capital to net plant Return on total capital Times interest charges earned Net plant to sales (plant turnover) In order to determine the impact of capitalization upon financial ratios, it is necessary to look beyond the ratios themselves and find out just what each ratio is trying to measure. If we consider the many different items on a balance sheet and income statement, there are literally hundreds of possible permutations and combinations of these figures. Rather than engage in an encyclopedic tabulation of these ratios, it is better to have in mind a concept of what we are trying to learn about the firm's position, and then use or devise the appropriate com- parison.1 Once we know ”what it is we are trying to learn about a firm's position, " we will be able to judge whether the ratios which reflect the capitalization of leases are more or less effective than those that do not. Examination of the foregoing list soon makes it apparent that these ratios vary greatly in usefulness. In fact, some of them seem to pre- sent meaningless relationships. Furthermore, not all of them will be equally influenced by capitalization of leases. Because of this, the list of ratios has been divided into major and minor components. Major Ratios The major ratios which would be affected by capitalization are as follows: debt to equity, debt to total capital, times interest charges earned, return on total capital, the current ratio, fixed assets to tangible net worth, and funded debt to net plant. Debt to Equity One of the most important areas of financial analysis concerns itself with the relative proportions of debt and equity in a firm's capital 1Robert W. Johnson, Financial Management (Boston: Allyn and Bacon, Inc., 1959). p. 54. 110 structure. This relationship can be seen most clearly by computing a ratio of debt to equity or a ratio of debt to total capital. The former ratio is computed by dividing the total liabilities by the total stock- holders' equity. The latter ratio is computed by dividing the total liabilities by the total assets.1 Both of these ratios attempt:to . measure the relative proportion of total assets that have been supplied respectively by the owners and the creditors. The assumption normally made in making either of these analyses is that a certain amount of debt is desirable. This assumption is based on the financial principle of "trading on the equity" or "financial leverage, " which was mentioned previously. "Financial leverage" simply means that profits or losses are amplified by the existence of debt in a firm's capital structure. This principle is illustrated in Exhibit 20. Company L has a debt to equity ratio of fifty per cent and therefore employs "financial leverage. " Company U, on the other hand, has a debt to equity ratio of zero. Notice that the common stock of the levered com- pany (Company L) makes a greater return during years when profits before interest and after taxes exceed $10, 000. However, in years when profits are less than this breakeven point the common stockholders earnings are reduced by unfavorable leverage. As with other financial ratios, it is neither possible nor desirable to establish a workable rule of thumb from which one can determine the acceptable debt ceiling. z This is a matter that must be determined l"Total capital" as it is used in the ratio of debt to total capital refers to the sum of the liabilities plus the stockholders' equity and is therefore equal to the total assets. 2Some writers have suggested an empirical rule-of—thumb maximum. For example, Guthmann states: "For public utilities, the maximum per- centage for funded debt in the capital structure may be set at 60 per cent; and for railroads, because of the lower earning power of their property investment, at 50 per cent. Although individual manufacturing and merchandising concerns have 111 by the careful and considered judgment on the part of the analyst and will vary widely from firm to firm and from industry to industry. However, the primary basis for this determination is the level and the stability of corporate earnings. The higher and more stable the earn- ings, the higher the ratio of debt to equity that is permissible. Times Interest Charges Earned Another important ratio which is closely related to the debt to equity ratio is the times interest charges earned. The objective of this ratio is to measure the extent of "cushion" available to the funded debt in case future earnings do not meet expectations. A firm with a long history of relatively high and stable earnings could tolerate a lower ratio of times interest charges earned than could a company with highly volatile earnings. Thus, the number of times that interest charges must be earned varies directly with the instability of the firm's earnings. The times interest charges earned is computed by dividing the income (after deducting all operating expenses and taxes) by the bond interest charges. For example, if the income after the deduction of all operating expenses and taxes is $40, 000 and the interest on the bonds is $10, 000, the interest charges have been earned four times. The situation is slightly more complex when there is more than one issue of bonds, because a separate computation must be made for each issue. Where such is the case, the total income before interest and after taxes is divided by the sum of the interest charges on the particular issue, plus the interest charges on all prior issues. Such a shown as much or even more stability than the public service corpora- tions, the general opinion has been that bonds should occupy a smaller place in their capital structure. A maximum limit of one third would probably obtain for industrials, subject to a possible further limitation in the light of the earnings record, the character of the business, and the extent to which short-term credit is used. "1 1Harry G. Guthmann, Analysis of Financial Statements (Englewood Cliffs, N..I.: Prentice—Hall, Inc., 1953), p. 158. Earnings per Share 112 1 EXHIBIT 20 Illustration of Financial Leverage $20 " $15 - :1: Company L $10 ‘ >:<>;< Company U $5 — 5 10 15 20 Earnirigj Before Interest, After Taxes (In Thousands of Dollars) *Company L: l, 000 shares $100 par value common stock. $100, 000 5% mortgage bonds. **Company U: 2, 000 shares $100 par value common stock. No debt. Gain from favorable leverage. \ Loss from unfavorable leverage. 113 calculation will reflect the fact that the fortune of a junior issue is linked closely to that of the senior issues. For example, assume an (issue of $1, 000, 000 of four per cent First Mortgage Bonds and an issue of $500, 000 of five per cent General Debentures. If the company had earnings after deducting all operating expenses and taxes of $200, 000, then the times interest charges earned on the senior issue would be 5 times ($200, 000 ~I- $40,000) and on the junior issue would be 2.11 times ($200,000 -j— [840, 000 + $25, 000]). Return on Total Capital The return on total capital (return on total investment) is studied as a measure of a firm's general earning power. It measures the return from utilizing a bundle of assets without giving consideration to how these assets were financed, i. e. , by debt or equity funds. The return on total capital is computed by dividing the net operating income (income after taxes but before interest or dividends) by the total capital (liabilities plus stockholders' equity). The ratio attempts to isolate the return from operations from that which has come about from "trading on the equity. " It is a measure of how effectively management has employed the resources which have been intrusted to it from whatever source. Some writers have questioned the advisability of including liabili- ties, such as accounts payable and accrued liabilities, in the above 1 The reason for their concern is the fact that these sources calculations. of capital do not represent explicit rights to share in earnings. Regard- less of the claims these creditors may or may not hold, however, the liabilities nevertheless represent an important source of assets which management must effectively employ and should be included in the firm's total capital in computing the above ratio. 1William A. Paton and William A. Paton, Jr. , Corporation Accounts and Statements (New York: The Macmillan Company, 1955), pp. 492-497. 114 The Current Ratio Probably the most widely known financial ratio is the current ratio. Its purpose is to measure the firm's general debt-paying ability within the near future, generally one year from date of computation. The current ratio is calculated by dividing the current assets by the current liabilities. For example, if a firm has current assets of $3 million and current liabilities of $1 million, its current ratio is three to one or three times. If the ratio is less than one to one then the firm is thought to be verging on insolvency. To the extent that the ratio exceeds one to one, there exists some ”cushion" of current assets over current liabilities. Almost as well-known as the ratio itself is the often suggested rule-of—thumb standard of two-to-one. As mentioned previously, such rules-of—thumb are to be discouraged, since financial analysis is an individual matter; and a ratio which is perfectly acceptable in the case of one company may be totally inadequate for another. Because it has been so widely used, and because of the stereotype imposed by the application of rule-of—thumb standards, the current ratio has been the subject of much abuse. To begin with, it has been implied that the higher the ratio, the sounder the company. Actually, this is far from the truth. A ratio may be too high just as well as too low. A management which accumulates excess cash and cash equivalent will soon build up a high current ratio. This may well be a sign of stagnation rather than of an astute management. One might well take a look at the classic case of Montgomery Ward during the post second world war era. In this instance, the high current ratio was probably not a sign of an alert and progressive management. Another possible misuse of the current ratio is found in the failure of the analyst to go beyond the ratio to the items that go to make it up. 115 This is really not a weakness of the ratio itself, but of the analyst, and is an example of the practice of confusing the means for the end which was described previously. An increased current ratio may well be a sign of a business "slowdown“ as excess inventory is accumulated and the collection of accounts receivable "slows" up. Again, the analyst must be reminded to stop, look and listen, and then proceed with extreme care. The Cash Budget It has been suggested that a firm's current debt paying ability could be estimated more accurately with a cash budget, rather than with the current ratio. The cash budget is a statement in which the analyst lists the expected cash receipts and expenditures over a specified period of time. In addition to measuring the firm's debt paying ability, the cash budget provides a system for cash management whereby excess funds can be profitably invested and shortages properly planned for. Exhibit 21 is an example of a cash budget. A major weakness of the cash budget stems from its failure to reflect fully the timing of cash flows. To be effective, it is usually necessary that the cash budget be prepared on a monthly basis. Even though the monthly cash budgets may indicate that the cash balance at the end of each month will be maintained at a safe level, this does not mean that the company will remain solvent during the month. A "cash crisis" may arise as expenditures pile up at the beginning of the month, while cash collections come in rather uniformly throughout the month. In such a case the monthly cash budget would not be effective. In some instances a weekly or even semi-weekly budgets may be necessary to fully reflect the timing of flows. .Such a practice would be very time consuming, and because of the many estimates involved would probably not be accurate . 116 EXHIBIT 21 Cash Budget Work Sheet Jan. Feb. March April May June Receipts _*M 1. Sales 5,000 8,000 18,000 20,000 28,000 26,000 Collections on accounts receivable 4, 800a 5,000 8,000 18,000 20,000 28,000 Payments 1. Purchases 6,400 8,000 8,800 8,800 8,800 8,000 Payments on accounts b payable 5,880 6,272 7,840 8,624 8,624 8,624 2. Wages 1,600 1,600 2,000 2, 200 2,200 2,200 3. Direct factory 1,700 1,700 1,700 1,800 1,800 ' 1,800 4. Admin. expenses 700 700 700 800 800 800 5. Selling expenses 900 900 1, 300 1, 400 l, 400 1, 400 6. Purchase of equip. l, 000 Payment for equip. l, 000 Operating transactions Receipts: Collections $4,800 $5,000 8,000 $18,000 $20,000 $28,000 Payments: Payments on accounts payable 5,880 6,272 7,840 8,624 8,624 8,624 Wages 1,600 1,600 2,000 2,200 2,200 2,200 Direct factory 1, 700 1, 700 1, 700 l, 800 1, 800 1, 800 Admin. expenses 700 700 700 800 800 800 Selling expenses 900 900 l, 300 1, 400 1, 400 l, 400 Payment for equip. l, 000 10,780 11,172 13,540 15,824 14,824 14,824 Net monthly cash gain loss (5, 980) (6,172) (5, 540) 2,176 5,176 13,176 Cash balance, E. O. M. 12/31$7,400 $1,420 ($4,752) ($10,292) ($8,116) ($2,940)$10,236 Financial transactions Cash balance, B.O.M.C $7,400 $1, 420 $1,248 $2, 708 $7, 884 $11, 060 Borrowings (repayments), B.O.M. 0 6,000 7,000 3,000 (2,000) (8,000) Total 7,400 7,420 8,248 5, 708 5, 884 3,060 Net monthly cash gain (loss) (5, 980) (6, 172) (5, 540) 2, 176 5, 176 13, 176 Cash balance, E.O.M. d $1,420 $1,248 $2,708 $7,884 $11,060 $16,236 Cumulative borrowings, B.O.M. 0 $6,000 $13,000 $16,000 $14,000 $6,000 a'Accounts receivable, December 31; bAccounts payable, December 31, less 2% cash discount; CBeginning of month; End of month. Source: Robert W. Johnson, Financial Management (Revised ed.; Boston: Allyn and Bacon, Inc. , 1962), pp. 97-98. Reprinted by permission of the publisher. The current ratio also ignores the time element in cash flows. It reflects only the assets which are cash or will be converted to cash within the normal operating cycle and liabilities which will require cash for payment during the same period of time. It in no way indicates when (during the period) the assets will become cash nor when the liabilities must be paid. The major advantages of the current ratio over the cash budget are the simplicity of calculation and the fact that the required information is readily available to the analyst. It provides only a fraction of the detail of a cash budget, but requires only a fraction of the time. In most instances, the current ratio should serve as a crude estimate of a firm's debt paying ability. Fixed Assets to Tangible Net Worth The ratio of fixed assets to tangible net worth is computed by dividing the fixed assets (net of depreciation and amortization) by the stockholders' equity. The purpose of the ratio is to determine the extent to which the firm has tied its investment up in fixed assets thereby limiting the funds available to meet working capital requirements. Dun and Bradstreet has suggested the following rule-of—thumb as a guide: The relationship between Fixed Assets and Tangible Net Worth should not exceed 100 per cent for a manufacturer, and 75 per cent for a wholesaler or a retailer. Beyond these limits, so disproportionate an amount of capital is frozen into machinery or "bricks and mortar" that the necessary margin of operating funds for carrying receivables, inventories and day-to-day cash outlays, as well as maturing obligations becomes too narrow. This not only exposes the business to the hazards of unexpected developments, such as a sudden change in the business climate, but creates possible drains on income in the form of heavy carrying and maintenance charges should a serious portion of Fixed Assets lie idle for any length of time. 1 Funded Debt to Net Plant The ratio of funded debt to net plant is computed by dividing the 1Dun and Bradstreet, Inc., _o_p_. 53.1" p. 7. 118 funded debt (long-term liabilities) by the fixed assets (net of depreci- ation and amortization). Fixed assets are typically acquired by permanent capital, which may have been provided by either creditors or owners or some combination of the two. The purpose of this ratio is to measure the relative proportions that have come from each source. Since the fixed assets are usually pledged against the long-term debt, the ratio of funded debt to net plant would be of major importance to these creditors. The ratio of funded debt to net plant, as a comparison of fixed assets and long-term debt, has its counterpart in the current _1;a_ti_o, which makes a similar comparison among the current assets and liabilities. This ratio has not as yet gained wide acceptance in financial circles. It is included here because it is a ratio which should be sub- stantially affected by capitalization. Minor Ratios The ratios which are affected by capitalization of leases, but which play a less important role in the financial analysis of a firm, or else are relatively unaffected by capitalization, are considered in this section. The eight ratios included in this classification are: funded debts to net working capital, net profits on net working capital, net sales on net working capital, current debt to tangible net worth, inven- tory to net working capital, current debt to inventory, net working capital to net plant, and net plant to sales. Funded Debts to Net Working Capital An extension of the current ratio to the needs of the bondholders is found in the ratio of funded debts to net working capital. "Net working capital" may be defined as the difference between current assets and current liabilities. The ”funded debts" are all long term obligations, 119 as represented by mortgages, bonds, debentures, term loans, serial notes, and other types of liabilities maturing more than one year from statement date. It may be difficult to see the relationship between "net working capital" and "funded debt, " Since the bonds are often secured by a lien on the fixed assets rather than on current assets. In answer to this alleged inconsistency, Guthmann states: Actually, the bondholders are recognizing two important factors; namely, (1) the greater ease of valuing the current assets as compared with the fixed assets, and (2) the virtue of a strong working capital in supporting interest charges during a period when earnings are temporarily inadequate. l Certainly it cannot be denied that a firm's current position has a direct bearing on the security of the bondholders. The current ratio is an indication of the extent to which working capital may be available to meet interest charges and other pressing requirements during a period when earnings are temporarily inadequate. The ratio of funded debts to net working capital attempts to go one step further by recog- nizing that the greater the funded debt, the greater the ”cushion" that may be required as a "hedge" against contingencies. The ratio of funded debts to net working capital does have some drawbacks, however. First of all, since it is so closely related to the current ratio, the weaknesses noted there are also applicable here. We cannot say that a high ratio is necessarily good or bad _p_e_1_'_ s3; Further, it seems difficult to see any direct relationship between "working capital" and "funded debt. " This ratio is one which may deserve an occasional glance, but there are others which might com- mand more of the attention of the bondholder. Net Profits on Net WorkiniCapital The net working capital of a firm is computed by subtracting its 1Guthman, pp. 21.2" p. 161. 120 current liabilities from its current assets. The resulting amount represents a "cushion" which is available to the business to finance current operations. The ratio of net profits on net working capital is obtained by dividing net profits (after taxes) by the net working capital. This ratio has been the subject of wide misuse. It implies that profits are earned on working capital only and that all other assets are non-productive parasites. An example of this misuse was pre- sented in Chapter 11 where the publication of the Foundation for Manage- ment Research, "The Pros and Cons of Leasing, "was discussed. Promotional literature published by leasing companies has also implied that fixed assets are "frozen" and that only working capital is essential for profitable operations. While the importance of working capital cannot be denied, it is nevertheless only one of the factors which con- tribute to profit. All of the resources of a firm, from whatever source supplied, jointly generate profits; and a relationship which implies otherwise is faulty and actually may be misleading. Net Sales to Net Working Capital The ratio of net sales to net working capital (sometimes called working capital turnover) is computed by dividing the net sales by the net working capital. The ratio recognizes that there is a direct relation- ship between sales and the amount of working capital required. It gives an indication of whether increased sales are being financed largely by payables or from increased working capital. The ratio is subject to all of the criticism previously made of the current ratio. Its limitations are summarized in the following statement: If the business suffers from a relatively high current debt--that is, has a low current ratio--the business will show a relatively higher ratio of sales to working capital. A high work- ing capital turnover may reflect efficient receivables and mer- chandise turnover, but it may just as well reflect a dangerously low current ratio. But a ratio which can tell either of such opposite stories is a blur of a number of relationships.1 1Ibid., p. 122. 121 Current Debt to Tangible Net Worth The ratio of current debt to tangible net worth is obtained by dividing the current debt by the total stockholders' equity. This is another of the many ratios designed to measure the relationship of debt to, equity and to assure that an adequate proportion of the funds are supplied by the owners. Dun and Bradstreet cautions that "a business begins to pile up trouble when the relationship between Current Debt and Tangible Net Worth exceeds 80 per cent. "1 Inventory to Net Working Capital The ratio of inventory to net working capital is calculated by dividing the merchandise inventory by the net working capital. The purpose of the ratio is to measure the proportion of working capital that is tied up in unsold inventory. If the ratio becomes too high, then the firm will likely experience difficulty in meeting its current obli- gations. This ratio would be most meaningful when used in connection with the inventory turnover and the current ratio. Current Debt to Inventory The ratio of current debt to inventory is obtained by dividing the current liabilities by the merchandise inventory. The purpose of the ratio is to measure the extent to which a firm relies on the funds pro- vided by the sale of merchandise to meet its current obligations. Since a large proportion of the sales of many firms are made on credit, the current ratio is probably a better measure of a firm's current debt paying ability. Net Working Capital to Net Plant The ratio of net working capital to net plant is computed by divid- ing the net working capital by the total fixed assets (net of depreciation 1Dun and Bradstreet, Inc. , op. cit. 122 and amortization). The relationship seems to be rather meaningless, but presumably is intended to show the relative proportions of permanent capital which are tied up, in working capital and in fixed assets. Net Plant to Sales The ratio of net plant to sales (sometimes called the plant turn- .9335.) is computed by dividing the total fixed assets (net of depreciation and amortization) by sales. The result is the dollar of sales during the year per dollar of plant investment. The objective of the ratio is to measure the efficiency with which fixed assets have been adminis- tered. Guthmann lists two major advantages of high plant turnover: 1. The larger the volume of business with respect to investment, the less is the per cent of net profit on sales required to earn a given rate of return on investment. 2. The company with a low ratio is presumably obliged to spread the fixed expenses resulting from the use of the fixed assets, such as depreciation and interest, and generally insur- ance and taxes, over a relatively smaller volume of business, and consequently is likely to be at a disadvantage from a com- petitive standpoint.1 The ratio of net plant to sales may fail to measure accurately the efficiency of management in administering fixed assets because: 1. Price level changes. Sales tend to vary with changes in the level of prices, but plant usually remains on the books at cost until its parts are worn out or discarded and new units entered at the going level of prices. 2. Operating functions assumed. Sometimes two concerns are engaged in apparently the same business, but upon closer scrutiny it is found that one performs more functions than the other--a fact that justifies additional investment. lGuthmann, pp. git” p. 162. 123 3. Depreciation reserves. If the net fixed assets after the deduction of depreciation are used in this ratio, two concerns with equal plant costs but of different ages might show, as a result, different plant turnovers.1 The Impact of Capitalization The fifteen ratios discussed in the preceding section were calcu- lated from the financial statements presented in Appendix III. Separate computations were made from the figures ”as reported" and the amounts "as adjusted" in order to isolate the effect of capitalization. The ratios "before capitalization" and "after capitalization" for the eleven selected companies are summarized in Exhibit 22. Capitalization Improves Ratios An analysis of the data in Exhibit 22 soon makes it apparent that some of these ratios are affected quite substantially. This fact imme- diately raises several questions. First of all, what causes the ratios to be so affected, i. e. , what happens to the components from which the ratios are computed? This is answered in the first two columns of Exhibit 23. The first column indicates that ten of the numerators used in computing the ratios increased, four remained unchanged, and only one decreased, as a result of capitalization. In the case of the denomi- nators (column 2), six were greater, four were smaller, and five re- mained unchanged after capitalization. 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AS 3v 3: E ANV NV 3 129 A final question which might be raised is related to the ratio ob- jectives which were outlined in the previous section. Does capitalization help these ratios meet their objectives, i. e. , do the ratios measure what they are trying to measure more or less accurately after capitaliza- tion? This question is answered in column 4 of Exhibit 23, where it is noted that in all instances (where the ratios themselves are meaningful) the ratios are made more meaningful by capitalization. Impact on Financial Analysis Exhibit 23 and the discussion which follows make it clear that the ratios considered in this chapter meet their objectives better after capitalization than they do before capitalization. This fact raises another question of importance: Are the ratios changed enough to have a signifi- cant effect on financial analysis? i. e. , would the decisions which the financial analyst would make based upon the analysis of these ratios be any different if leases were capitalized than if they were not? This question is answered in part by Exhibit 24 where the eleven lessee companies are ranked both before and after capitalization for each ratio. In each case the company with the most favorable ratio is given the highest ranking. In order to isolate the effect of capitalization on any particular ratio, each one was considered independently of the others. For example, the ranking of the current ratios indicates how each com- pany stood in relation to each of the others in regard to the current ratio 2n_1_y . Reading on Exhibit 24 across the lines, we find how each of the companies listed at the top ranked in regard to each of the ratios listed at the left; first, before capitalization (shown as BC), and then, after capitalization (shown as AC). This exhibit emphasizes several important points. First of all, in all cases but one (the return on total capital) the ranking is different after capitalization than it is before. This means that, other things EXHIBIT 24 RANKING OF LESSEE COMPANIES BY RATIO BEFORE AND AFTER CAPITALIZATION ° ouI ‘sionpOJd lOl‘EIOlnd ’leD 1}‘e.to 'IFV P99191301 Auedmog Buying -o'e~}nuew 191nm °ouI ‘uonxol 'dxog p003 psiepnosuog ouI 391013 puog 99.1013 Sula SQIdOQd Aueduxog) Ill-IOMIOOM 'M '._-I uonexodlog 991033 PSIIIV “oul ‘ 39.1013 Aemsyzs Auedvuog inn: 3; uuad BC AC Leased assets to 10 11 total as s ets BC AC Leased assets to 130 10 11 net plant 11 10 10 BC AC Current ratio 11 ll 11 10 BC AC Debt to equity 10 ll 11 10 BC AC Debt to total capital 10 ll 10 10 BC AC Return on total 11 c apital 11 10 8 10 Times interest charges BC 11 10 AC earned ll 11 BC AC Fixed assets to 10 tangible net worth 10 10 11 11 BC AC Funded debt to net plant 131 .GoSuONSSOuSQOo HON—Sq. .GoSuONSSOu—SQOO OHOSOm O< Um I‘M (fir-O ofim'd‘Nxofi \ON GO \O'd‘ r-{r—4 AH mo~\o SS SS SS SS SS SS SS NM FI‘OO‘ meO‘V‘NFV“ C‘V‘ '—‘\O .S.‘ thO OO‘ (I‘d) V‘fi" (13(1) V‘fl" V‘fl‘ [\(‘O‘F (\Ln wVf‘OLn V‘N MN (130 SS Nm SS SS 2 oS anmooxooo mm mm me (~me SS SS M MNxOxo NN LD\ON 0‘0" 0000 $00 NNxO‘d‘ 0’3th LOO‘ SS oS SS oS oS oS oS HNr—fi Nmmmmmoom1~t~oooo Ml" r—fl F4 04 0m 04 0m 04 Om O< 0m U4 US 0.4. 0m U4 US 0.4. on mOSOm ou— uaOSnS uOZ “GOSQ On 8. SOuSmOo wcSvSHOB «OZ SOHSQOU mcSuSHOB HO: o» unSOU UOUGDM >u0ucO>cS o» HQOU ucOuusO SOOSQOO mGSvSHOB ”SO: 3 >u0ucO>cS 5.83 On OSnSS umCOu o» unSOU ucOHHDO SOHSQOO mcSvSHOB ”SO: 3 OOSOO uOZ SOOSQOO wcSuSHOB HOG co mfimoum “OZ 132 remaining equal, the financial analyst will make faulty decisions if he bases his analysis on any of the ratios (except the return on total capital) which have been computed from the figures presented in conventional financial statements. The number of firms which were given a different ranking as a result of capitalization is also of significance. Of the eleven companies, the following number were given a different ranking after capitalization from that which they had before: Current ratio Debt to equity Debt to total capital Return on total capital Times interest charges earned Fixed assets to tangible net worth Funded debt to net plant Net profits on net working capital Net sales to net working capital Current debt to tangible net worth Inventory to net working capital Current debt to inventory Funded debt to net working capital Net working capital to net plant Net plant to sales var—- mU'lxlNU‘INIOOOQOKI Hy—a Hp—a \O In 56 per cent of the cases (92 out of 165 observations), there was a spread of two or more places between the firms' positions before and, after capitalization. In 7 per cent of the cases (11 out of 165 observations), the spread was six or more places. For example, Miller Manufacturing Company ranked eighth in regard to the ratio of debt to equity prior to capitalization, but actually ranked second after giving consideration to the capitalized leases. Exhibit 24 illustrates further that the companies which. lease a high percentage of their assets are the ones which are hurt most by capitali- zation. The firm making the greatest use of leases, Penn Fruit Company, fell in the rankings twelve times, remained the same twice, and improved only once. At the other extreme, Purolator Products, Inc. , the firm 133 which used leasing to the smallest degree, improved in the rankings ten times, remained unchanged four times, and dropped only once. The four firms making the greatest use of leasing fell in the rankings thirty-five times, remained unchanged fourteen times, and improved only eleven times. On the other hand, the four firms that made relatively little use of the lease as a means of financing were higher in the rankings thirty-five times, unchanged twenty-one times, and lower only five times . Dangers of Current Reporting Some of the dangers of current techniques for reporting of long- term leases are made more apparent by this pilot study. For example, an analysis of the published financial statements of Safeway Stores, Inc. and Consolidated Food Corporation reveals that they have almost identical ratios of debt to total capital (Safeway 41. 5 per cent and Consolidated Food 41. 7 per cent). Since these companies are both members of the same industry, one would conclude that from the standpoint of relative pro- portion of assets supplied by "outsiders" the two companies are compar- able; and, other things being equal, the degree of "risk” would be the same. An investor contemplating the purchase of some stock or the banker considering a loan application would consider the companies a "standoff. “ Consider now this same ratio calculated for the same two companies from financial statements in which leases have been capitalized. Instead of the almost identical ratios which were noted above, we find that Safeway has a substantially higher ratio (70. 6 per cent) than does Consolidated Foods (52. 6 per cent). Neither the proportion of funds supplied by out- siders nor the relative "risk" is comparable for the two firms as implied by the preceding calculations. The truth of the matter is that the ratios which were computed from the published financial statements were based 134 upon incomplete data and, accordingly, are inaccurate and misleading. The investor or banker acting on this information would have been mis- led because a very significant portion of the assets supplied by "outsiders" were omitted from the calculations. Similar comparisons may be made with other ratios. For example, the current ratio of F. W. Woolworth Company is 3.43 times before capitalization and is comparable to the 3.40 times of the Purolator Products, Inc. Based on this comparison one might conclude that the two firms should meet their current obligations with equal ease. Comparison of the two companies after capitalization reveals that Purolator Products with a current ratio of 3. 35 times is in a much stronger current position than is F. W. Woolworth Company with a current ratio of 2. 13 times. Other significant comparisons include times interest charges earned of Penn Fruit Company and Consolidated Food Corporation of 6. 3 times and 6. 1 times, respectively, before capitalization and l. 6 times and 3. 3 times, respectively, after capitalization. The ratio of fixed assets to tangible net worth before capitalization of F. W. Woolworth at 67.6 per cent is comparable to that of Textron, Inc. , at 68.1 per cent. After capitalization these same ratios are 154.4 per cent and 93.0 per cent, respectively. CHAPTER VII SUMMAR Y AND CONC LUSIONS Summary The purpose of this study has been to measure the impact of leasing on conventional financial analysis. It has been concerned, first, with an evaluation of current reporting techniques, and second, with an appraisal of the suggested alternatives. The major criterion used in making this evaluation has been the impact that each proposal would have on conventional financial ratios. Long-term leases were classified as service or financial, the distinction being made on the basis of when the lessor performed his part of the contract. It was found that the economic and financial facts surrounding each type of lease were distinctive and accordingly required very different recording in the books of account, as well as disclosure in the financial statements. It was noted that current reporting was adequate with regard to the service lease and that it was proper to re- port this type of transaction on the balance sheet only to the extent that rentals were prepaid or accrued. . Current reporting of financial leases, however, was found to be unsatisfactory because it ignored the similarities between the lease and the more conventional forms of debt financing. This failure to recog- nize leasing as a means of financing resulted in distorted and misleading financial statements. This deficiency in current reporting was traced, first, to inadequate requirements which were laid down by the American Institute of Certified Public Accountants and the Securities and Exchange Commission, and second, to the failure of the accounting profession to comply with the obvious intent of these requirements. 135 136 The arguments for and against leasing were examined in an attempt to determine the extent to which inadequacies in current reporting may have contributed to the wide-spread use of the lease as a financing device. In this connection, it was noted that much of the case presented in favor of leasing rested upon "illusory" arguments which were based upon faulty reporting. Although these arguments were initially advanced by the leasing industry, they soon became accepted as factual by many "independent" parties. This general misunderstanding of the nature and limitations of the lease probably contributed to its rapid growth and carried the transaction well beyond the bounds which could be justified on economic grounds. It was noted that to the extent that current report- ing contributed to this unhealthy condition, the accounting profession was responsible. Three alternatives to the current techniques for reporting financial leases were examined: first, the supplementary schedule; second, capitalization with the amounts shown short in the balance sheet; and third, capitalization with the amounts included in the balance sheet 1 The first of these proposals was dismissed on the grounds that totals. the supplementary schedule was nothing more than an expanded form of footnote. The second proposal, capitalization with the amounts shown short, was not considered as a satisfactory solution because it too failed to reflect fully the financial implications of lease agreements. It was regarded as even less satisfactory than the supplementary schedule, since under the former the reader may have been misled by the fact that the amounts were shown in the body of the balance sheet and yet did not "count. " Capitalization with the amounts included in the balance sheet totals was found to be the only proposal which was examined that could satis- factorily overcome the deficiencies in current reporting previously mentioned. Under this proposal the capitalized value of the future lease 1Hereafter referred to as capitalization. 137 rentals would be included among the firm's assets as “rights to use leased property at discounted amount of related long-term rental obligations. " This same amount would be included among the firm's liabilities, the current portion under the caption "current lease rentals, " and the balance under the heading "rental obligations under long-term leases (discounted at implicit rates of interest). " The appropriate amount would be computed by discounting the rentals payable during the term of the lease at the interest rate implied in the particular agreement. This latter proposal recognized the economic and financial fact that leasing was a means of financing and that as such it should be fully disclosed in the published financial statements. Contrary to the objections which were raised against it, capitalization was found to be deeply rooted in accounting theory and completely compatible with current principles of accounting. In order to compare capitalization with current reporting, it was necessary to reconstruct some financial statements with capitalized amounts included therein. This proved to be a difficult task because sufficient information was typically not provided in the published financial statements to enable the reader to make a reasonable estimate of the discounted value of the lease rentals. The rentals were usually shown for only one year, or else covered a period two broad to be meaningful. Expiration dates were rarely shown, and in no case was the implied interest rate or original cost indicated. This lack of sufficient data not only limited this thesis to a pilot study of eleven companies, but also illustrated further the inadequacies in current reporting. . It was noted that the accountant has not only failed to reflect leases in the balance sheet, where they belong, but worse than this, he has failed even to provide sufficient information in the footnotes to enable someone else to make the necessary adjustments. 138 Fifteen financial ratios were considered in evaluating the impact of leasing on conventional financial analysis. The ratios considered were: the current ratio, the debt to equity ratio, the ratio of debt to total capital, the return on total capital, times interest charges earned, the ratio of fixed assets to tangible net worth, the ratio of funded debt to net plant, the ratio of net profits on net working capital, the ratio of net sales to net working capital, the ratio of current debt to tangible net worth, the ratio of inventory to net working capital, the current debt to inventory ratio, the ratio of funded debt to net working capital, the ratio of net working capital to net plant, and the ratio of net plant to sales. These ratios, after capitalization, were substantially different from those which were computed before capitalization. Those which were most affected by capitalization were: debt to equity, debt to total capital, times interest charges earned, fixed assets to tangible net worth, funded debt to net plant, funded debt to net working capital, and net working capital to net plant. The ratios were analyzed to determine what impact capitalization would have upon them. It was found that twelve of the ratios made the firm's financial position appear to be worse after capitalization. One of the ratios (return on total capital) followed no definite pattern, i. e. , in some instances the firm's position was "improved" by capitalization, and in other cases just the reverse was true. Two of the ratios (net profits _on net working capital and net sales to net working capital) presented a more favorable financial position after capitalization. Both of these latter ratios, however, were found to have limitations which minimized the importance of this implied improvement in financial position. All of the ratios, except the two just noted, were found to be more meaningful after capitalization. 139 All eleven companies analyzed in the study were ranked both before and after capitalization for each ratio. In all cases but one (the return on total capital) the ranking was different after capitalization than it was before. This was interpreted to mean, other things remain- ing equal, that the financial analyst would have made faulty decisions had he based his evaluation of these firms on the financial ratios com- puted from conventional financial statements. Conclusions Many important conventional financial ratios are made meaningless by current reporting practices with regard to extensive financial leasing. The ratios which are most affected are those concerned with fixed assets, long-term liabilities and interest charges. The fact that the ratios do not accurately measure what they are intended to measure does not stem from weaknesses in the ratios themselves but instead from faulty pro- cedures for reporting leases which are primarily financial in nature. Capitalization is a sound process for overcoming the weaknesses in current reporting and for properly reflecting the financial impact of leasing in the financial statements. It is a process which is compatible with generally accepted accounting principles and merely an extension of the long-recognized concept of looking through legal details to the financial and economic facts. Because capitalization recognizes leasing for what it really is, a means of financing, the financial ratios which are com- puted from statements containing capitalized leases are meaningful. These ratios are, of course, subject to the general limitations of ratio analysis; however, they are much more valid than ratios computed from conventional financial statements and therefore make inter-company comparisons much more meaningful. 140 Although financial statements are basically representations of management, the accounting profession must assume the responsibility for the inadequacies in current reporting. There are generally accepted accounting and auditing standards upon which the financial statements are based, and these are determined not by management but by the accounting profession. Business managements have tended to lean on minimum standards of reporting and accordingly have not capitalized leases in their financial statements because no requirement to do so has existed. Although no organization has the power to decree accounting and reporting standards, the American Institute of Certified Public Accountants and the Securities and Exchange Commission do have a profound influence on their development. These organizations must take the initiative if any widespread change is to be adopted. Some day the truth about leas- ing will be out and the "illusions" will vanish. If the accounting pro- fession takes the initiative in bringing this about, the prestige of the profession will be enhanced. On the other hand, if no action is taken by the accounting profession until the financial analysts have perfected techniques for revising the published financial statements so that they do reflect the financial facts, then it is this latter group who will be considered the professionals. In this case, the accounting profession will take a big step backward toward the long-accepted stereotype of bookkeeping. Accounting is a profession, and as such must assume the respons- ibility for adopting new reporting techniques to reflect properly the changing nature of the business world. Leasing has been developed by the financial world as a new means of financing, and the accounting profession must quickly respond by adopting a new device which will properly reflect this new transaction. 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Falstaff Brewing Corporation; 5050 Oakland Avenue; St. Louis, Missouri. Mohasco Industries, Incorporated; Amsterdam, New York. Peoples Drug Stores, Incorporated; 60 Florida Avenue, N. E.: Washington 2, D. C. Sinclair Oil Corporation; 600 Fifth Avenue; New York 20, New York . Dresser Industries, Incorporated; Republic National Bank Building; P. O. Box 718; Dallas 21, Texas. Lockheed Aircraft Corporation; P. O. Box 551; Burbank, ‘California. Montgomery Ward and Company, Incorporated; 619 West Chicago Avenue; Chicago 7, Illinois. Sears, Roebuck and Company; 925 South Homan Avenue; Chicago 7, Illinois. Crown Zellerback Corporation; 1 Bush Street; San Francisco 19, California. Erie Forge and Steel Corporation; Erie, Pennsylvania. The May Department Stores Company; 6th and Olive Streets; St. Louis, Missouri. The Ryan Aeronautical Company; 6 State Street; Bangor, Maine. Safeway Stores, Incorporated; 4th and Jackson Streets; Oakland 4, California. 155 156 Allen Industries, Incorporated; Leland Avenue at G. T. R. R.; Detroit 7, Michigan. The American Hardware Corporation; New Britain, Connecticut. Federated Department Stores, Incorporated; 222 West 7th Street; Cincinnati 2, Ohio. W. T. Grant Company; 1441 Broadway; New York 18, New York. Keystone Steel and Wire Company; Peoria 7, Illinois. Purolator Products, Incorporated; 970 New Brunswick Avenue; Rahway, New Jersey. Canada Dry Corporation; 100 Park Avenue; New York 17, New York. R. H. Macy and Company, Incorporated; 151 West 34th Street; New York 1, New York. Pepsi-Cola Company; 500 Park Avenue; New York 22, New York. Alco Products, Incorporated; 530 Fifth Avenue; New York. 36, New York. Calumet and Hecla, Incorporated; 122 South Michigan Avenue; Chicago 3, Illinois. Interstate Bakeries Corporation; 12 East Armour Blvd.; Kansas City 11, Missouri. Lerner Stores Corporation; 354 Park Avenue South; New York 10, New York. J. J. Newberry Company; 245 Fifth Avenue; New York 16, New York. Penn Fruit Company, Incorporated; Grant Avenue and Blue Grass Road, Philadelphia 15, Pennsylvania. Air Reduction Company, Incorporated; 150 East 42nd Street; New York 17, New York. Consolidated Foods Corporation; 135 South La Salle Street; Chicago 3, Illinois. The Garrett Corporation; 9851-9951 Sepulveda Blvd.; Los Angeles 45, California. 157 Miller Manufacturing Company; 17640 Grand River Avenue; Detroit 27, Michigan. Saco-Lowell Shops; 60 Batterymarch Street; Boston 10, Massachusetts. Textron Incorporated; 10 Dorrance Street; Providence 3, Rhode Island. National Cylinder Gas Company; (now Chemetron Corporation); 840 N. Michigan Avenue; Chicago 11, Illinois. Northrop Aircraft, Incorporated; (now Northrop Corporation); 9744 Wilshire Blvd.; Beverly Hills, California. J. C. Penney Company; 330 West 34th Street; New York 1, New York. F. W. Woolworth Company; Woolworth Building; New York 7, New York. Century Electric Company; 1806 Pine Street; St. Louis, Missouri. Burroughs Corporation; 6071 Second Avenue; Detroit 32, Michigan. Allied Stores Corporation; 401 Fifth Avenue; New York 16, New York. Kayser-Roth Corporation; 425 Fifth Avenue; New York 16, New York. APPENDIX II SCHEDULES OF LEASE RENTALS 158 Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1978 1979 1980 1981 1982 1983 1984 159 APPENDIX II-l PENN FRUIT COMPANY Schedule of Lease Rentals* Rental Payable $3, 467, 817\ 3, 467, 817 3, 467, 817 3, 467, 817 3,467,817 >- 3,467,817 3,467,817 3,467,817 3,467,817,, 2,808,932‘\ 2,808,932 2,808,932 2,808,932 2,808,932 2,808,932 2,808,933 2,808,932 2,808,932 2,808,932 2,808,932 2,808,932 2,808,932 > 2,808,932,) Discount Factor at 6% 6. 801692 5 . 748666 Present value of lease rentals Dis c ounted Value $23, 587,000 16,147,600 $39, 734, 600 3 >3 . Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 160 APPENDIX II—2 SAFEWAY STORES, INC. Schedule of Lease Rentals* Rental Payable $41,400,000 41,400,000 41,400,000 41,400,000 41,400,000 41,400,000 40,200,000 39,000,000-W 39,000,000 39,000,000 39,000,000 39,000,000 39,000,000 39,000,000 39,000,000 > 39,000,000 39,000,000 J 21,550,000 4,100,000 4,100,000 4,100,000 4,100,000 4,100,000 4,100,000 4,100,000 4,100,000 Discount Factor at 6% 4.917324 .665057 4. 894879 . 350344 2.175563 Present value of lease rentals >‘.< Dis c ounted Value $203, 577, 200 26,735, 300 190, 900, 300 7, 549, 900 8, 919, 800 $437, 662, 500 Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. 161 APPENDDCH-3 ALLIED. STORES CORPORATION Schedule of Lease Rentals’“ (with Alstores Realty Corporation) Discount Rental Factor Discounted Year Payable at 6% Value 1961 $9,131,000 1962 9,131,000 1963 9,131,000 4.917324 $44,900,100 1964 9,131,000 1965 9,131,000 1966 9,131,000 1967 9,105,000 .665057 6,055,300 1968 9,105,000 .627412 5,712,600 1969 9,072,000 [591898 5,369,700 1970 9,039,000 1971 9,039,000 2.050991 18,538,900 1972 9,039,000 1973 9,039,000 1974 9,019,000 .442301 3,989,100 1975 9,000,000 1976 9,000,000 1.532619 13,793,600 1977 9,000,000 1978 9,000,000 1979 8,511,000 .330513 2,813,000 1980 8,021,000 1981 8,021,000 1.145263 9,186,200 1982 8,021,000 1983 8,021,000 1984 7,284,000 .246979 1,799,000 1985 6,545,000 1986 6,545,000 1.055806 6,910,300 1987 6,545,000 1988 6,545,000 1989 5,496,000 .184557 1,014,400 1990 4,445,000 1991 4,445,000 :}- .639509 2,842,600 1992 4,445,000 1993 4,445,000 1994 3,796,000 .137912 523,500 1995-2005 3,145,000 1.087691 3,420,800 Present value of lease rentals 3‘: $126,869,100 'Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. ALLIED STORES CORPORATION Schedule of Lease Rentals* 162 A PPENDIX II- 4 (other than with Alstores Realty Corporation) Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995-2005 2006-2015 R ental Payable $5,064,000 5,064,000 5,064,000 5,064,000 5,000,000 4,971,000 4,921,000 4,921,000 4,775,000 4,627,000 4,627,000 4,627,000 4,627,000 4,260,000 3,891,000 3,891,000 3,891,000 3,891,000 3,014,000 2,136,000 2,136,000 2,136,000 2,136,000 1,947,000 1,757,000 1,757,000 1,757,000 1,757,000 1,330,000 901,000 901,000 901,000 901,000 889,000 876,000 688,000 Discount Factor at6%5 3.465106 .747258 .704961 .665057 .627412 .591898 2.050991 .442301 1.532619 .330513 1.145263 .246979 1.055806 .184557 .639509 .137912 1.087691 .068538 Present value of lease rentals Discounted Value $17,547,300 3,736,300 3,504,400 3,272,700 3,087,500 2,826,400 9,489,900 1,884,200 5,963,400 996,200 2,446,300 480,900 1,855,100 245,400 576,200 122,700 952,800 47,200 $59,034,900 * Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 163 APPENDIX II- 5 Rental payable $44,270,000 44,270,000 42,316,000 40,362,000 40,362,000 40,362,000 40,362,000 37,712,000 35,062,000 35,062,000 35,062,000 35,062,000 35,062,000 35,062,000 35,062,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 11,913,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 4,626,000 2 > F. W. WOOLWORTH COMPANY Schedule of Lease Rentals* Disc ount Factor at 6% .943396 .889996 . 839619 2.909369 . 627412 3 . 502455 3.071107 1.714890 Present value of lease rentals Discounted Value $41, 764,100 39, 400,100 35, 529,400 117,428, 000 23, 661, 000 122, 803,100 36, 586,100 7,933,100 $425,104, 900 >’.= Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. ' 164 APPENDIX II-6 PEOPLES DRUG STORE Schedule of Lease Rentals* Discount Rental Factor Discounted Year Payable at 6% Value 1961 $2,481,200 .943396 $2,340,754 1962 2,481, 200 .889996 2,208, 258 1963 2,203,543 .839619 1,850, 137 1964 l, 925, 886 . 792094 1, 525, 483 1965 1,925,886 .747258 1,439,134 1966 1,925,886 .704961 1,357,675 1967 1, 925,886 .665057 1, 280,824 1968 1,726,946 .627412 1,083,507 1969 1,528,006 .591898 904,423 1970 1, 528,006 .558395 853,231 1971 1, 528,006 .526788 804,935 1972 l, 528, 006 . 496969 759, 372 1973 1, 330,628 .468839 623,850 1974 1,133,250 .442301 501,238 1975 1,133,250 .417265 472,865 1976 1,133, 250 .393646 446,099 Present value of lease rentals $18,451, 785 >:< Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 165 APPENDIX II-7 BOND STORES, INC. R ental Payable $2, 972,000 2,972,000 2,972,000 2,972,000 2,972,000 2,735,000 2,539,000 2,539,000 2,539,000 2,539,000 2,120,000 1,701,000 1,701,000 1,701,000 1,701,000 1,701,000 1,701,000 1,701,000 402,000 402,000 402,000 402,000 402,000 402,000 Schedule of Lease Rentals* Dis c ount Factor at 6% .943396 .889996 .839619 .792094 .747258 .704961 .665057 .627412 .591898 .558395 .526788 .496969 .468839 .442301 .417265 .393646 .371364 .350344 .330513 .311805 .294155 .277505 .261797 .246979 Present value of lease rentals Dis c ounted Value $2,803,773 2,645,068 2,495,348 2,354,103 2,220,851 1,928,069 1,688,580 1, 592, 999 1,502,829 1,417,765 1,116,791 845,344 797,495 752,354 709, 768 669, 592 631, 690 595,935 132,866 125,346 118,250 111,557 105,242 99, 286 $27, 460, 901 I 3' ‘Estimated from information contained in the Form 10-K filed with the Securities and Exchange Commission. See Chapter V. Year 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 166 A PPENDIX II- 8 R ental Payable $4, 449, 000 4,449,000 4,449,000 3,942,000 3,433,000 3,433,000 3,433,000 3,433,000 2,708,000 1,981,000 1,981,000 1,981,000 1,981,000 1,385,000 787,000 787,000 787,000 787,000 421,000 53,000 53,000 53,000 53,000 1 1 1 1 ], Disc ount Factor at 6% 2.673012 . 792094 2 . 744688 . 591898 2. 040991 .442301 1.532619 . 330513 .—I . 392242 Present value of lease rentals >l annual report . CONSOLIDATED FOODS CORPORATION Schedule of Lease Rentals* Discounted Value $11,892,200 3,122,400 9,422, 500 1,602, 900 4,043, 200 612,600 1, 206, 200 139,100 73,800 $32,114, 900 'Estimated from information contained in the company's See Chapter V. 167 APPENDIX II-9 IJDCFGIEEHDIKHUSRJUFT'CCHAPTHVY Schedule of Lease Rentals"< Discount Rental Factor Discounted Year Payable at 6% Value 1961 $3,700,000 1962 3,700,000 1963 3,700,000 4.212364 $15,585,700 1964 3,700,000 1965 3,700,000 1966 2,625,000 .704961 1,850,500 1967 1,550,000 ‘ 1968 1,550,000 1969 1,550,000 1970 1,550,000 1971 1,550,000 } 5.188571 8,042,300 1972 1,550,000 1973 1,550,000 1974 1,550,000 1975 1,550,000 1976 1,550,000 2 Present value of lease rentals $25, 478, 500 3:: Estimated from information contained in the company's annualreport See Chapter V. 168 APPENDIX II- 10 TEXTRON, INC. . Schedule of Lease Rentals‘" Discounted value of leases as shown in a footnote to annual report $29, 700, 000. APPENDIX II- 1 1 MILLER MANUFACTURING COMPANY Schedule of Lease Rentals One lease with an annual rental of $76, 962 for 21 years. 11. 764077 (discount factor) times $76, 962 (annual rental) = $905, 387. APPENDIX II- 12 PUROLATOR PRODUCTS, INC. Schedule of Lease Rentals"< One lease with an annual rental of $87, 640 for 17 years. 10.477260 (discount factor) times $87, 640 (annual rental) = $918, 227. >1: Estimated from information contained in the company's annual report. See Chapter V. APPENDIX III FINANCIAL STATEMENTS OF 11 SELECTED COMPANIES 169 170 APPENDIX III-l PENN FRUIT CO. , INC. and Subsidiaries Consolidated Balanc e Sheet August 26, 1961 ASSETS Current Assets: as reported* Cash on hand, in transit and demand deposits $ 3, 761, 984 United States Treasury Notes . . Trade accounts receivable Other accounts rec eivable ........... Inventories of merchandise and supplies at cost or market, whichever is lower . . . Prepaid Expenses . . . . . . . . . TOTAL CURRENT ASSETS . Investments and Other Assets: Loans secured by mortgages on leased premises Cash surrender value of insurance . Cash balances held in sinking, purchase and conversion funds for Preferred stocks Investments in and advances to affiliated and associated companies--at cost . TOTAL INVESTMENTS AND OTHER ASSETS ............... Plant and Equipment (at cost): Land ...................... Buildings ...... . . . Furniture and equipment Transportation equipment . . Improvements to leases premises Less--accumulated allowances for depr. Rights to use of leased property, at discounted amount of related long-term rental obligations ........... TOTAL PLANT AND EQUIPMENT. Deferred Charges ....... . . . . ..... TOTAL ........ >i‘-<=Io.mmmw O¢N.¢so.¢SS 66m.moc.mm mom.mm6.m ooo.ooo.v oon.¢OS.wS 80S.mmp.662 mmm.om~.o m66.SoS.SS Sm¢.oS¢.w mmm.wSo.GS SSM.MSv.sN Noo.o~o.mmvw wem.omN.S S~>.Soa.wSN om~.ow¢.m www.8ww.v oom.>oo.mo Som.omw.6 avo.mow.oo mom.oSn.mN a mOoGOSOm UOSOUSOOGOO mmofiomJNwmmoflomew maegKmmsww Sofifiomdwflw.... ...meR::fioq mGS>GGOo HOG GO>0 OoSGnS OOSOO S0 mmOome 0000 .9: .vS ome .ooS .SVS . QGOO OOHOSm UOSS< 80pm mOoGO>U< 68636 $94.36: . . . . . . . . . .8558 663869 82.2: 292: 63.392 . . . . . . . . . . .6388 8:960 n225.08...“ 08.08.... . . . .8; 639 .28 £68... $68.60 $988.... . . . . . SE... .88 8.318 688 SGGOGGO .OGSO> GOQuOG .vSooum GoGGGGoU ooo .oooO . mOSGOm UGOOOO 68¢ .vSooum UOGGOSOGnS oowOoS .wS . . . . .OOSGOO $26 £03m UOGGOGOGQ $8 .2: .SS Sm .38 .3 86> 6:6 Sam. 36 .566 828-364 6? .82. .w m? .28 .86.» 6:6 £58? 62.6 3% 868-864 w-.2mm mmo.oow.oS . . .. . .. .moxmoocsochSmhmemm” va 6:65 08“ OGGooGS SOGOUOh GOG» .850 £889. mpo.¢n6 68m.mwm.oS .. .. . .. . .. 666cmmx6.665666<. 22.3.3; 8 ENG? 2862.8 8 . . . . . . . . . .6388 8568.4. 24.3.8. 48% 88.3352“. .. . . . . .mEmmo 4.3.05 00m .33 mmo .mwm OOGOnSxO B.OU GGGOuumGoS UONSSGOGGOGD 335mm 39»: 5: 30.813 . . . 658888 28 22¢ 5.8865 oooo .9: .SS coo .ooS .SVS . .aGoO >SSOOm OOGoSmS< 0S mOoGO>U< nmSm .mOS. .m mSm .mow .m .980 >SOO~S OOGOSOS< GS OSGOGSOO>GS om~.oww.m . . . . .OSOOOO .838 GS OSGOGSOO>GS ¢vw6ww€ . . . . . . . . . . OOOGOnSxO USOaOunS oowfioodo . . . . . . OOSGoSGO>GS OOSUGOGOGOSZ SOmeNAVXw ...............mh®£u0 11OSSO>SO0OG OOGOG UGO 399000.64 6284.46S.S a Sna.ewS.S vwo.mom.oo . .. . .. . .. . .. . mquxsmso 11OSQO>SOOOG mOSOG UGO 35500.4 maimed a NOS.SVmw.va.................GOOU SSUOGO SSnSOQ GoSuOGOnSGOO GoSSOGOnSGOO GOSSOGSESH >SOO~S mOuopm >GOQGGOOGOSGS OOGOSOS< UOSSS< SUoS .Sm >GOGGOS. So mO OoGOSOm SOSGH wGSmoS01Sm0nS UOSOUSSOOGoU ZOSrSUoJSOnHMSOO >H1Si< as adjusted** Current Liabilities: ' Accounts payable ................. $ 17,091,430 $ 17,091,430 Accruals and sundry liabilities, including taxes withheld .............. . ...... 47, 706, 546 47, 706, 546 Long-term debt payable within one year ..... 2, 884, 614 2, 884, 614 Income taxes payable ............. . . 4, 596, 442 4, 596, 442 Current lease rentals ............... -0- 44, 270, 000 TOTAL CURRENT LIABILITIES ....... 72, 279, 032 116, 549, 032 Long-Term Liabilities: Long-term debt payable after one year . . . . . 130, 608, 888 130, 608, 888 Rental obligations under long-term leases (discounted at implicit interest rates) ..... i . -0- 380, 835, 000 TOTAL LONG-TERM LIABILITIES ...... 130, 608, 888 511, 443, 888 Reserves: For self-insurance to cover fire 81 flood damage risks on contents of stores in U. S. . . 3, 765, 606 3, 765, 606 For U. S. employees' sick benefits ....... 300, 000 300, 000 For German employees' pensions ........ 1, 798, 244 1, 798, 244 TOTAL RESERVES . . . . . . ........ . 5,863,850 5,863,850 Shareholders' Equity; Capital stock--par value $10 per share: Authorized--20, 000, 000 shares Issued--9, 750, 000 shares ........... 97, 500, 000 97, 500, 000 Earned surplus .................. 388, 294, 703 388, 294, 703 . 485,794,703 485,794,703 Deduct--Stock held in treasury, 46, 394 shares, at cost less $901, 634 previously charged to earned surplus . . . .............. l, 647, 080 l, 647, 080 TOTAL SHAREHOLDERS' EQUITY . . . . . . 484, 147, 623 484, 147, 623 TOTAL . . . . . ............... $92, 899, 393 $1,1184 0044 393 SELECTED INCOME STATEMENT DATA Net Sales . . . ............... . . . $1,035,292,793 $1,035, 292,793 Net Income (after taxes) ............. 46, 927, 512 46, 927, 512 Interest Charges . . . ........... . . . 6, 306, 406 31, 812, 706 179 APPENDIX III-6 PEOPLES DRUG STORES and Subsidiary Corporations Consolidated Balance Sheet 1960 December 31, ASSETS as reported>=< as adjusted“. Current Assets: Cash. . ..... . . . . . . . $ 5,391,863 $ 5,391,863 Accounts receivable, less reserve for doubtful accounts. . . . . . . . . . 1,031,768 1,031,768 Merchandise inventories, at the lower of cost or market . . . 12, 962, 727 12, 962, 727 Merchandise in transit, at cost . 695, 273 695, 273 Inventory of supplies, at cost . 69, 730 69, 730 Prepaid expenses . 282, 579 282, 579 TOTAL CURRENT ASSETS 20, 433, 940 20, 433, 940 Other Assets . ..... 65, 359 65, 359 Fixed Assets, at cost or less: Land. . . . 533, 965 533, 965 Buildings on owned and leased land. 3, 093, 510 3, 093, 510 Store fixtures, warehouse and office equipment 12, 601, 939 12, 601, 939 Automobiles and trucks ...... . . . . . . . 362, 827 362, 827 Improvements and alterations to leased buildings 907, 982 907, 982 Rights to use of leased property, at discounted amount of related longfterm rental obligations -0- 18, 451, 785 17,500,223 35,952,008 Less reserves for depreciation and amortization . . . ..... 6,172,160 6,172,160 TOTAL FIXED ASSETS 11, 328, 063 29, 779, 848 _Coodwill . ..... 1 1 Deferred Charges . 195, 267 195, 267 TOTAL . . . . $32, 022,630 $50,474,415 *See note 1. **See note 2. Long-term lease commitments: Minimum annual rentals totaling $2, 481, 200 (not including any taxes or insurance that may be payable under the terms of the leases) are payable by the Companies under leases on properties used in opera- tions at December 31, 1960, covering periods of more than one year from December 31, 1960. . 180 LIABILITIES AND SHAREHOLDERS' EQUITY as reported>l= Current Liabilities: Accounts payable ................. $ 5,123, 591 Accrued expenses and other liabilities ...... 1, 625, 864 Federal and state income taxes ......... 1, 246, 593 Current lease rentals ............... -0- TOTAL CURRENT LIABILITIES ....... 7, 996, 048 Long-Term Debt: Notes payable to bank, unsecured, due after one year ................. . . . . -0- Rental obligations under long-term leases (discounted at implicit interest rates) . . . . . -0- TOTAL LONG-TERM DEBT ..... . . . . -0- Miscellaneous Reserves .............. 211, 586 Long-Term Lease Commitments (Note 2). . . . Shar eholde r 3' Equity: 621-70 Cumulative Preferred Stock: Authorized--75, 000 shares, par value $100 Noneissued. . . . . . . . ........... Common, par value $5: Authorized--750, 000 shares Outstanding--550, 000 shares ...... . . . . 2, 750, 000 Capital surplus ................. . 5, 559, 838 Retained earnings ................. 15, 505, 158 TOTAL SHAREHOLDERS' EQUITY . . . .. . 23, 814, 996 TOTAL ..................... $32, 022, 630 SELECTED INCOME STATEMENT DATA Net Sales ...................... $93,184, 720 Net Income (after taxes) .............. 1, 311, 774 Interest Charges .................. 49, 679T TNot shown in Annual Report, furnished directly by company. as adjusted>l<>=< $ 5,123,591 1,625,864 1,246,593 2,481,200 10,477,248 -0- 15, 970, 585 15, 970, 585 211, 586 2,750,000 5,559,838 15,505,158 23, 814, 996 $50,474, 415 $93,184,720 1,311,774 1,156,787 181 A PPENDIX III- 7 BOND STORES, INCORPORATED and Wholly-Owned Subsidiaries Consolidated Balance Sheet as atihfly'31, 1960 ASSETS Current Assets: Cash. . . . . . . . . . . Short- term state and municipal bonds-—at cost, which approximates market, plus accrued interest ................ Accounts receivable--customers (net) Miscellaneous accounts receivable . Merchandise inventories TOTAL CURRENT ASSETS Miscellaneous Other Assets Fixed Assets: Land and buildings . . . Machinery, furniture, fixtures and equipment . Alterations, improvements and leaseholds . Less- -reserves for depreciation Rights to use of leased property, at discounted amount of related long-term rental obligations ......... TOTAL FIXED ASSETS Deferred Charges: Prepaid rent and advances to landlords. . Unexpired insurance and other prepaid expenses TOTAL DEFERRED CHARGES TOTAL . . . . . . ..... *See note 1. **See note 2. General: As at July 31, 1960, property leases, amounts to approximately $2, 972, 000. as reported* . $ 9, 609, 272 5, 555,086 12, 344, 975 496, 577 21, 012, 967 as adjusted“- $ 9,609,272 5,555,086 12,344,975 496,577 21,012,967 49, 018, 877 49, 018, 877 341,461 9, 505,862 7,426,696 6, 602, 833 23,535,391 10,837,409 341,461 9, 505, 862 7, 426, 696 6, 602, 833 12, 697, 982 -0- 23,535,391 10,837,409 12, 697, 982 12, 697, 982 27,460,901 848, 685 806, 300 40,158, 883 1, 654, 985 848, 685 806, 300 .863,713,305 1,654,985 $91,174,206 the aggregate minimum annual rental upon real other than intercompany leases, expiring after July 31, 1963, Certain of these lease agreements pro- vide for additional rentals based on sales or for payment of certain expenses, such as real estate taxes and maintenance costs. 182 LIABILITIES AND SHAREHOLDERS' EQUITY as reported* Curr ent Liabilities: Accounts payable . . . . . ........ . . . . $ 1,584,020 Deposits and due to customers ...... . . . . 399, 763 Accrued expenses and sundry liabilities . . . . . 2, 905, 936 Reserve for Federal income taxes ...... . . 1, 515, 456 Mortgage bonds payable--current installments . 126, 656 Current lease rentals ........... . . . . -0- TOTAL CURRENT LIABILITIES . . . . . . . 6, 531, 831 Long— Term Liabilities: Mortgage bonds payable by subsidiary . . . . . . 2, 177, 344 Rental obligations under long-term leases (discounted at implicit interest rates) . . . . . -0- TOTAL LONG-TERM LIABILITIES . . . . . . 2, 177, 344 Capital Stock and Surplus: Preferred stock--par value $100 per share: Authorized-— 100, 000 shares Retired and cancelled--60, 000 shares Authorized but not issued--40, 000 shares Common stock--par value $1.00 per share: Authorized-~2, 500, 000 shares Issued and outstanding--1, 688, 383 shares . . . 1, 688, 383 Capital surplus .................. 11, 596, 136 Earned surplus ..... . . . . ....... . . 41, 719, 611 TOTAL CAPITAL . . . . ........... 55, 004, 130 TOTAL . . . . . . . .......... . . . . $63, 713,;305 SELECTED INCOME STATEMENT DATA Net Sales . . . . . .......... . . . . . . . $85,062,632 Net Income (after taxes) . . . . . ..... . . . . 2, 556, 696 Interest Charges . ..... . . . . . ..... . . 7, 987T 1'Not shown in Annual Report.. Furnished directly by company. as adjusted** $ 1,584,020 399, 763 2, 905, 936 1,515,456 126, 656 2,972,000 9, 503, 831 2,177,344 24, 488, 901 26, 666, 245 1,688,383 11, 596,136 41, 719,611 55, 004,130 $91,174,206 $85, 062, 632 2,556,696 1, 655,641 183 APPENDIX III- 8 CONSOLIDATED FOODS CORPORATION and Subsidiarie 5 Consolidated Balanc e Sheet June 30, 1961 ASSETS Current Assets: Cash--includes $357, 877 U. S. Treasury Bills Accounts and notes receivable (net) . . Inventories, at lower of cost or market . Advances to growers . . ..... . . . . . Properties under construction, to be sold and leased back, at cost ....... . Prepaid insurance, taxes, and expenses. TOTAL CURRENT ASSETS ...... Fixed Assets: Land, building, machinery, and equipment, at cost less accumulated depreciation of $32,733, 988. . Rights to use of leased property, at discounted amount of related long- -term rental obligations. TOTAL FIXED ASSETS . . Other Assets and Deferred Charges: Long term notes and contracts receivable . Cash value of life insurance . . . ..... Leasehold improvements (net) . Long term debt expense (net) ........... Sundry noncurrent assets and deferred charges . TOTAL OTHER ASSETS AND DEFERRED CHARGES ....... . . ....... Intangible As 8 ets: Excess of purchase price of businesses acquired over net assets at dates of acquisition ..... Goodwill, trade-marks, and other intangibles . . TOTAL INTANGIBLE ASSETS . TOTAL ............ >“See note 1. >’=*See note 2. as reported>=< $10,144, 997 16, 608, 731 54,948,069 937,695 331, 581 1, 635, 988 84, 607, 061 42, 969, 719 .0. 42,969,719 2,266,879 393,298 3,059,331 25,493 1,110,109 6, 855,110 5,008, 374 4 5,008, 378 $139,440, 268 Commitments and Contingent Liabilities: See note 3. as adjusted“? $10,144, 997 16, 608, 731 54, 948,069 937,695 331,581 1, 635, 988 84,607,061 42, 969, 719 32,115,000 75,084,719 2,266,879 393, 298 3,059, 331 25,493 1, 110,109 6, 855,110 5, 008, 374 4 5,008,378 $171,555,268 184 LLABILITIES AND SHAREHOLDERS' EQUITY as reported==< as adjusted“< Current Liabilities: Notes payable to banks ............ . . $ 3, 000, 000 $ 3, 000, 000 Accounts payable ................. 19, 043, 784 19, 043, 784 Long term debt payable within one year ..... 3, 677, 890 3, 677, 890 Federal income taxes payable and accrued . . . 5, 473, 001 5, 473, 001 Other taxes payable and accrued ......... 3, 459, 341 3, 459, 341 Accrued salaries and wages, interest, and other expenses ................. 2, 974, 514 2, 974, 514 Current lease rentals .............. -0- 4, 449, 000 TOTAL CURRENT LIABILITIES . . ..... 37, 628, 530 42, 077, 530 Long Term Liabilities: Long term debt .................. 20, 566, 262 20, 566, 262 Rental obligations under long-term leases (discounted at implicit interest rate) ...... -0- 27, 666, 000 TOTAL LONG TERM LIABILITIES ...... 20, 566, 262 48, 232, 262 Capital Stock and Surplus: Common stock--$l. 33-1/3 par value: Authorized--5, 000, 000 shares Reserved for stock options--115, 858 shares Issued and outstanding--3, 686, 306 shares, after deducting 50, 061 shares held in treasury 4, 981, 823 4, 981, 823 Paid-in surplus .................. 46,813,921 46,813,921 Capital surplus .................. 9, 504, 220 9, 504, 220 Earned surplus .................. 21, 966, 875 21, 966, 875 83,266,839 83,266,839 Deduct -- stock held in treasury, at cost . . . . 2, 021, 363 2, 021, 363 TOTAL CAPITAL STOCK AND SURPLUS . . 81, 245, 476 81, 245, 476 TOTAL ..................... $139, 440,268 $171,555, 268 SELECTED INCOME STATEMENT DATA Net Sales ...................... $509,280,716 $509,280,716 Net Income (after taxes) ............ . . 8, 096, 310 8, 096, 310 Interest Charges . . . ............... 1, 599, 884 3, 526, 784 185 APPENDIX III-9 TEXTRON, INC. Consolidated Balance Sheet December 31, 1960 ASSETS as reported>l< as adjusted“ Current Assets: Cash ........ . . . . . . . . . . . . . . . . $15,099, 572 $15,099. 572 United States Government securities, at cost . . 5, 083,156 5, 083, 156 Accounts receivable. . . . . ..... . . . . . . 49,142,491 49,142,491 Inventories, at lower of cost or market . . . . . 83,147, 913 83, 147, 913 Prepaid and deferred expenses . . . . . . . . . . 2, 335, 727 2, 335, 727 Other current assets . . . . . . . . . . . . . . . 4, 583, 426 4, 583,426 TOTAL CURRENT ASSETS . . . . . . . . . . 159, 392, 285 159, 392, 285 Investments: Notes receivable, due after one year. . . . . . . 4, 503, 336 4, 503, 336 Investment in Textron Electronics, Inc. , at cost, adjusted for equity in income . . . . . . . 8, 650, 682 8, 650, 682 TOTAL INVESTMENTS . . ..... . . . . . 13,154, 018 13,154, 018 Property, Plant and Equipment: Land and buildings . . . ........... . . 38, 254, 785 38, 254, 785 Machinery and equipment . . . . . ..... . . 88, 208, 699 88, 208, 699 Other property . . . . . . . ....... . . . . 6,826, 998 6,826, 998 133,290,482 133,290,482 Less reserves . . . . . . . ...... . . . . 52,126,828 52,126,828 81,163,654 81,163,654 Rights to use of leased property, at discounted amount of related long-term rental obligations. -0- 29, 700, 000 TOTAL FIXED ASSETS . . ...... . . . . 81, 163,654 110,863,654 Other Assets: Excess cost of companies acquired, less amort. 5, 322, 345 5, 322, 345 Unamortized debt discount and expenses . . . . 8, 623, 887 8, 623, 887 Other assets ............... . . . . 4,173,163 4, 173,163 TOTAL OTHER ASSETS ...... . . . . . 18,119, 395 18, l 19, 395 TOTAL . . . . . ...... . . ..... . . $271,829,352- $301, 529L352 >i=See note 1. **See note 2. Annual rentals payable under long-term leases are approximately $4, 600, 000 and the aggregate rentals payable under these leases, discountedto December 31, 1960, are approximately $29, 700, 000. Under certain leases Textron is also required to pay for insurance, taxes and repairs. 186 LIABILITIES AND SHAREHOLDERS' EQUITY as reported>1< Current Liabilities: Notes payable--banks . . . ........... . $14,890,000 Accounts payable . . .............. . 17, 550, 207 Accrued Expenses and other current liabilities . 22, 237, 586 Federal income taxes .............. . 3, 467, 360 Current maturities of long-term notes ...... 3, 906, 038 Amounts payable for companies acquired . . . . 1, 374, 021 Dividends payable ................. 1, 618, 383 Current lease rentals ............... -0- TOTAL CURRENT LIABILITIES ........ 65, 043, 595 Long-Term Debt: Note payable--The Prudential Insurance Company of America . . . ........... 25, 000, 000 Other notes ..... . . . . ........... 14, 302,302 Debentures--subordinated to all other debt. . . . 44, 217, 417 Amounts payable for companies acquired, due after one year ................... 3,150,000 Rental obligations under long-term leases (discounted at implicit interest rates) . . . . . . -0- TOTAL LONG-TERM DEBT ....... . . . 86, 669, 719 Other Liabilities . . . . . . .......... . . 940, 607 Capital Stock and Surplus: $1. 25 Convertible Preferred: Outstanding--368, 647 shares . ........ . 9, 216,175 Common Stock Outstanding--4, 672, 429 shares after deducting 313, 200 shares in treasury ......... . 2, 336, 215 Capital surplus (principally paid-in) 66, 444, 497 Earned surplus ............... . . . 41, 178, 544 TOTAL CAPITAL STOCK AND SURPLUS . . . 119, 175, 431 TOTAL . . .................. . $271,_8_29, 352 SELECTED INCOME STATEMENT DATA Net Sales ..... . ................ $383,187, 580 Net Income (after taxes) .............. 14,168, 301 Interest Charges . . . - 8- 112- 989 as adjusted“< $14,890,000 17,550,207 22,237,586 3,467,360 3,906,038 1,374,021 1,618,383 4,600,000 69,643,595 25,000,000 14,302,302 44,217,417 3,150, 000 25,100, 000 111, 769, 719 940, 607 9, 216,175 2,336,215 66,444,497 41,178,544 119,175,431 $301,529,352 1 $383,187,580 14,168,301 6-894-959 187 APPENDIX III- 10 MILLER MANUFACTURING CO. and Subsidiary Companies Consolidated Balance Sheet September 30 , 1960 ASSETS as reported=== as adjustedirf: Current Assets: Cash ..... . . . . . . . . . . . . . . $ 806,162 $ 806,162 Accounts receivable (.net) . . 1, 643, 678 1, 643, 678 Inventories, at lower of cost or market ..... 3, 369, 473 3, 369, 473 Prepaid expenses ....... . . . . . . . 115,439 115,439 TOTAL CURRENT ASSETS ...... 5, 934, 752 5, 934, 752 Other Assets: Cash surrender value of life insurance policies 193, 880 193, 880 Miscellaneous investments, deposits, and advances .......... . . . 88,430 88,430 TOTAL OTHER ASSETS . . ...... 282, 310 282, 310 Property, Plant, and Equipment: Land . . ............ 116,321 116,321 Buildings and improvements . 1, 557, 879 1, 557, 879 Machinery and equipment . . ..... 4, 165, 993 4, 165, 993 5,840,193 5,840,193 Less allowances for depreciation . 3, 021, 211 3, 021, 211 2,818,982 2,818,982 Rights to use of leased property, at discounted amount of related long- -term rental obligations .................. -0- 905, 387 TOTAL PROPERTY, PLANT, AND EQUIPMENT ........ 2,818,982 3,724,369 Deferred Charges: Unamortized bond discount and expense . 69, 557 69, 557 Unamortized patent licenses ...... 20, 115 20, 115 TOTAL DEFERRED CHARGES . 89, 672 89, 672 TOTAL . ................ $3,125,716 $10,031,103 *See note 1. **See note 2. Lease agreement: The Company is leasing the plant in Alliance, Ohio, for twenty- one years at an annual rental of $76, 962 plus taxes, repairs, and insurance. The company has an option to purchase the premises. 188 LIABILITIES AND SHAREHOLDERS' EQUITY as reported=l= as adjusted>=<>1< Current Liabilities: Note payable to bank . . . ....... . . $ 600, 000 $ 600, 000 Accounts payable and accrued expenses . . . . . . 1, 104, 741 1, 104, 741 Customers' deposits on orders ....... . . . 206, 015 206, 015 Dividends payable in October, 1960 ..... . . . 59, 298 59, 298 Sinking fund payment due August 1, 1961 . . . . . 205, 655 205, 655 Federal taxes on income ....... . . . . . . . 733, 538 733, 538 Current lease rentals . . . . . ..... . . . . . -0- 76, 962 TOTAL CURRENT LIABILITIES . . . . . . $2, 909, 247 $2, 986, 209 Long-Term Liabilities: 6% Sinking fund debentures due August 1, 1973 . . 940,845 940,845 Rental obligations under long-term leases (discounted at implicit interest rates) . . . . . . -0- 828, 425 TOTAL LONG-TERM LIABILITIES . . . . . . 940, 845 1, 769, 270 Stockholders' Equity: Class "A" Stock, $5 par value; entitled upon dissolution to $10 a share; cumulative 60¢ per annum: Authorized and outstanding--5, 087 shares . . . 25, 435 25, 435 Common Stock, $1 par value: Authorized--750, 000 shares Outstanding--585, 351 Shares ....... . . 585, 351 585, 351 Instalments received under stock purchase plan 92, 958 92, 958 Additional paid-in capital ......... 950, 987 950, 987 Accumulated net income retained ...... 3, 620, 893 +3, 620, 893 TOTAL STOCKHOLDERS' EQUITY . . 5, 275, 624 5, 275, 624 TOTAL ....... . ............ . 89425316 $10, 031,103 SELECTED INCOME STATEMENT DATA Net Sales . . ................ . . . . $16,121,877 $16,121,877 Net Income (after taxes) ............. . 913, 303 913, 303 Interest Charges . . . ........... . 136, 376 190, 699 189 APPENDIX III-11 LOCKHEED AIRCRAFT CORPORATION Consolidated Balance Sheet December 25, 1960 ASSETS Current Assets: Cash ..................... Accounts receivable--U. S. Government. . Other accounts receivable. . .......... Inventories ......... Prepaid expenses ........... TOTAL CURRENT ASSETS Investments, at Cost: Pacific Finance Corporation (market value $15,757,000) ..... . . Other ............ TOTAL INVESTMENTS Fixed Assets: Property, plant and equipment (net) Rights to use of leased property, at discounted amount of related long-term rental obligations . Deferred Charges TOTAL . . . . *See note 1. **See note 2. as reported* $ 30,242,000 174,445,000 49,735,000 176,184,000 15,034,000 $445, 640, 000 5, 469, 000 7, 490, 000 12, 959, 000 73, 871, 000 -0- 73, 871, 000 as adjustedi“? $ 30,242,000 174,445,000 49,735,000 176,184,000 15,034,000 $445, 640, 000 5, 469, 000 7,490,000 12,959,000 73,871,000 25, 479, 000 99, 350, 000 1, 906, 000 $534,376,900 1, 906,000 $59,855,000 Rent commitments under various long-term leases require annual payments excluding property taxes and insurance of from $4, 400, 000 to $3, 000, 000 through 1971 and from $2, 000, 000 to $1,100, 000 for the years 1972 to 1981. 190 LIABILITIES AND SHAREHOLDERS' EQUITY as reported* as adjusted“< Current Liabilities: Notes payable--banks ........... . . . . $ 70, 000, 000 $ 70, 000, 000 Accounts payable--trade ............. 135, 309, 000 135, 309, 000 Salaries and wages ............... . 27, 395, 000 27, 395, 000 Federal income taxes and renegotiation refunds . 8, 203, 000 8, 203, 000 Other taxes ................ . . . . 10, 784, 000 10, 784, 000 Customers' advances ........... . . . . 93, 560, 000 93, 560, 000 Retirement plan contribution . . . . . ...... 14, 294, 000 14‘, 294, 000 Other liabilities ................ . 28, 450, 000 28, 450, 000 Current lease rentals .............. -0- 3, 700, 000 TOTAL CURRENT LIABILITIES ....... . 387, 995, 000 391, 695, 000 Deferred Income . ............... . . 3,164, 000 3,164, 000 Long-Term Liabilities: 4. 50% Debentures--due 1976. .......... 28,125,000 28,125,000 3. 75% Subordinated debentures--due 1980 . . . . 11, 759, 000 11, 759, 000 Rental obligations under long-term leases (discounted at implicit interest rates) ..... -0- 21, 779, 000 TOTAL LONG-TERM LIABILITIES ..... 39, 884, 000 61, 663, 000 Stockholders' Equity: Capital stock, $1 par value: Authorized-- 14, 000, 000 shares Reserved for conversion of subordinated debentures--484, 508 shares Reserved for employees options--449, 467 Issued ...................... 7, 400, 000 7, 400, 000 Additional capital ................. 51, 834, 000 51, 834, 000 Earnings retained for use in business ...... 44, 099, 000 44, 099, 000 TOTAL STOCKHOLDERS' EQUITY ...... 103, 333, 000 103, 333, 000 TOTAL . . . . ................. $534, 376L000 $559,855,000 SELECTED INCOME STATEMENT DATA Net Sales ...................... $1,332, 289,000 $1, 332,289,000 Net Income (after taxes) .............. (42,934,000) (42,934,000) Interest Charges .................. 6, 604, 000 8,132., 740 191 APPENDIX III-12 PUROLATOR PRODUCTS, INC. and Subsidiaries Statement of Consolidated Financial Condition December 31, 1960 ASSETS as reported=i< as adjustedt'fr Current Assets: Cash. . . . . . . . . . . . . . . . . . . . . . $ 2,429,215 $ 2,429,215 Marketable securities, at cost . . . . . . . . . . 50, 000 50, 000 Receivables (net) . . . . . . . . . . . . . . . . . 4,438, 953 4, 438, 953 Inventories, at the lower of average cost or replacement market . . . . . . . . . . . . . . . 10,118, 605 10, 1 18, 605 Prepaid expenses. . . . . . . . . . . . . 1,660,219 1,660,219 TOTAL CURRENT ASSETS . . . . . . . . . . 18, 696, 992 18, 696, 992 Investments: U. S. Treasury bonds, at cost, less amortiz . . 150, 000 150, 000 Affiliated companies . . . . . . . . . . . . . . 394,256 394, 256 TOTAL INVESTMENTS. . . . . . . . . . . . 544, 256 544, 256 Plant and Equipment: Plant and equipment, at cost . . . . . . . . . . 10,150, 127 10, 150,127 Less accumulated depreciation. . . . . . . . . 3, 503, 842 3, 503, 842 6,646,285 6,646,285 Rights to use of leased property, at discounted amount of related long-term rental obligation . -0- 918, 227 TOTAL PLANT AND EQUIPMENT . . . . . . 6, 646, 285 7, 564, 512 Patents....................... 42,293 42,293 TOTAL . . . . . . ....... . . . . . . . $25, 929, 826 $26, 848, 053 *See note 1. **See note 2. The company leases its plant in Rahway, New Jersey, from the John Hancock Mutual Life Insurance Company. The lease expires on March 14, 1978 with three renewal options of ten consecutive years each. The annual rental amounts to $87, 640 or an aggregate of $1, 511, 790 from December 31, 1960. Pursuant to the terms of the lease, $150, 000 of U. S. Treasury bonds were deposited with the lessor to be returned in part in 1961 and completely in 1964. 192 LIABILITIES AND SHAREHOLDERS' EQUITY as reported=l< as adjusted‘n‘ofi< Current Liabilitie s: Mortgage note payable ............... $ 18, 833 $ 18, 833 Serial note payable ................. 300, 000 300, 000 Trade accounts payable .............. 2, 419, 331 2, 419, 331 Other accounts payable ........... 335, 017 335, 017 Accrued“. salaries, wages and vacations ...... 421, 998 421, 998 Accrued taxes, other than on income . . . 208, 607 208, 607 Miscellaneous accrued expenses ....... 639, 462 639, 462 Taxes on income, estimated ............ 1,158, 919 1,158, 919 Current lease rentals ............... -0- 87, 640 TOTAL CURRENT LIABILITIES ........ 5, 502, 167 5, 589, 807 Long-Term Debt: Serial note payable ................. 5, 550, 000 5, 550, 000 Mortgage payable . . . . .............. 122,182 122,182 Rental obligations under long-term leases (discounted at implicit interest rate) ....... -0- 830, 587 TOTAL LONG-TERM DEBT . . . . ...... 5, 672,182 6, 502, 769 Stockholders' Equity: Common stock, $1.00 par value per share Authorized-~2, 000, 000 shares Outstanding-~659, 149 shares ....... 659,149 659,149 Paid-in capital--excess of market value over par value of stock issued . . . . . . . . . . 8, 717, 764 8, 717, 764 Paid-in capital--excess of recorded value of net assets acquired over market value of stock issued . . . .................... 735,426 735,426 Retained earnings .................. 4, 643, 138 4, 643, 138 TOTAL STOCKHOLDERS' EQUITY ....... 14, 755, 477 14, 755, 477 TOTAL . . .................... $25, 929,826 $36,848, 053 SELECTED INCOME STATEMENT DATA Net Sales ...................... $48, 349, 971 $48, 349, 971 Net Income (after taxes) ............ 1, 918, 202 1, 918, 202 Interest Charges ......... . ........ 288, 053 343, 149 193 APPENDIX III- 13 NOTES TO FINANCIAL STATEMENTS Note 1: The figures shown in the "as reported" column are those reported in the company's annual report for the year indicated. All foot- notes to the financial statements have been omitted except those relating to leases. These footnotes have been numbered in the same manner as they appeared in the annual reports and are reproduced on the bottom of the first page of the balance sheets presented herein. Note 2'. The figure shown in the "as adjusted" column are the same as the "as reported" figures except that they have been adjusted to reflect the capitalization of leases. The following accounts have been adjusted: (a) The account "rights to use of leased property, at discounted amount of related long-term rental obligations" has been included in the "fixed asset" section. The computation of the amounts included under this heading are shown in Appendix II and are described in Chapter V. (b) The "current lease rentals" (rentals payable under long-term lease agreements within one year of the balance sheet date) have been in- cluded in the "current liabilities" section. (c) The "rental obligations under long-term leases (discounted at implicit interest rates)" (other than the rentals due within one year) have been included in the "long-term liabilities" section. ((1) "Interest" includes 6% of the amount shown under "rights to use of leased property, at discounted amount of related long-term rental obligations, " the amount of "financing" during the period. Note 3: Consolidated Foods Corporation's note 8 to the financial statements reads as follows: A number of properties are occupied by the Corporation and subsidiaries under long-term leases. Minimum annual rentals on such leases having an original life of more than five years average approximately $4, 309, 000 annually for years ending 1962-66, $3, 348, 000 in 1967-71, $1, 940, 000 in 1972-76, $787, 000 in 1977-81, and $53, 000 in 1982-86. Subsidiaries of the Corporation have guaranteed long-term leases with minimum annual rentals averaging approximately $140, 000 annually through 1966, $85, 000 from 1967 through 1971, and $41, 000 from 1972 through 1977. . 194 Note 4: Penn Fruit Company's note 5 to the financial statements reads as follows: The Company had 105 leases on properties in use expiring more than three years after August 26, 1961. Such leases call for minimum aggregate annual rentals totaling $3, 769, 153, of which about 24% relate to leases expiring within 15 years and the remainder relate to leases expiring from 15 to 31 years, with the exception of one lease expiring in 95 years. The Company had entered into additional long-term leases covering 11 proposed supermarkets which provide for estimated minimum aggregate annual rentals of $415, 000, the rentals to commence at the various dates of completion. The sum of $58, 339 in aggregate rent on leases of trans- portation equipment is payable in quarterly installments of vary- ing amounts through January 26, 1964. The leases contain options to purchase the equipment at prices declining in proportion to rentals paid. The sum of $441, 284 in aggregate rent on leases of auto- matic sprinklers is payable monthly in annual rentals of $151, 320 at various dates extending through August 14, 1967. The leases are subject to renewal at the option of the Company at nominal rentals. Only the 105 leases mentioned in the first paragraph of the above note were capitalized. It was assumed that the leases on transportation equipment and automatic sprinklers were service leases rather than financial leases and therefore would not be subject to capitalization. Note 5: The "as adjusted" column for Allied Stores Corporation was computed in a different manner from that of the other ten companies because many of Allied's leases are from a wholly-owned subsidiary, Alstores Realty Corporation. The latter company was not consolidated with other subsidiaries of Allied Stores Corporation in the published annual report. Instead, separate financial statements were included in the parent company's annual report. Because the purpose of capitalization is to place the assets and liabilities on the books at cost, it was deemed advisable to consolidate the balance sheets of the Allied Stores Corporation and the Alstores Realty Corporation (see Appendix III—4). This procedure eliminated the need for estimating the cost of assets leased from the subsidiary and the amount of the related lease liability. For purposes of comparison the 195 lease liability was also estimated by capitalization. The amount of the liability arising from the assets leased from Alstores Realty Corporation as determined by capitalization was $126, 869, 000 compared to the actual figure of $135, 641, 584 as shown on the company's balance sheet. This confirms the statement made in Chapter V that the six per cent implied interest rate used in the calculations was conservative in that it under- estimated the amount of the lease liability. The leases which Allied Stores Corporation had with outside con- cerns (other than with Alstores Realty Corporation) were capitalized in the same manner as were the leases for the other firms (see Appendix II-3). These figures were combined with the consolidated balance sheet of Allied Stores Corporation and Alstores Realty Corporation (see Appendix III-4), to produce the amounts shown in the "as adjusted" column for Allied Stores Corporation. 196 APPENDIX IV Chapter 14 of Bulletin 43 Disclosure of Long-Term Leases in Financial Statements of Lessees cum-:11 14 I ,. - senses an Disclosure of Long-Term Financial Statements of Lessees 1. THE GROWTH IN RECENT YEARS of the practice of using long-term leases as a method of financing: has created problems of disclosure in financial statements. In buy-haild-scll-and- lease transactions, the pur- chaser of Ian .thls to his own specixations, sells the impaoved preperty, and ;.111111ltaneously leases the property for a period of years. Similar transactions are the sale and lease of exit-1":g properties or the lease of prOperties to be constructed by the lessor to the speci- fications of the lessee. The lessee ordinarily assumes all the expenses and obligations of ownership (such as taxes, insurance, interest, main- tenance, and repairs) except payment of any mortgage indebtedness on the property. ' 2. There are many variations in such types of transactions. For example, some leases contain an option for acquisition of the prop- erty by the lessee, while other leases contain a requirement that the lessee purchase the property upon expiration of the lease. In some the price to be paid upon repurchase is related to the fair value of the property or the depreciated book value; in others it is an arbitrary amount with little or no relation to the protierty’s worth, or a nominal sum. Some leases provide for a high initial rental with declining payments thereafter or renewal at substantially reduced rentals. 3. Where long-term leases are used as a 51155;? 1: :‘ar e ..rship and mortgage borrowing a question arises as to the eaten: of disclosure to be made in financial statements of the fixed annual amounts payable and other important terms under such leases.1 4. Although the types of sell-and-Iease arrangements referred to in paragraph 1 differ in many respects from the conventional long-term xRule 3-18 (b) of Regulation S-X issued by the Securities and Exchange Commission reads: “Where the rentals or obligations under long-term leases are material there shall be shown the amounts of annual rentals under such leases with some indication of the periods for which they are payable, together with any important obligation assumed or guarantee made in connection therewith. If the rentals are conditional, state the minimum annual amounts.” - 197 II!» Restatement and Revision of Bulletins lease,2 the principles of disclosure stated herein are intended to apply to both. This chapter does not apply to short-term leases3 or to those customarily used for oil and gas pr0perties. 5. The committee believes that material amounts of fixed rental and other liabilities maturing in future years under long-term leases and possible related contingencies are material facts affecting judg- ments based on the financial statements of a corporation, and that those who rely upon financial statements are entitled to know of the existence of such leases and the extent of the obligations thereunder, irrespective of whether the leases are considered to be advantageous or otherwise. Accordingly, where the rentals or other obligations under long-term leases are material in the circumstances, the commit- tee is of the opinion that: (a) disclosure should be milde in financial statements or in notes thereto of: (l) the amounts of annual rentals to be paid under such leases with some indication of the periods for which they are payable and (2) any other important obligation assumed or guarantee made in connection therewith; (b) the above information should be given not only in the year in which the transaction originates but also as long thereafter as the amounts involved are material; and (c) in addition, in the year in which the transaction originates, there should be disclosrme of the principal details of any important sale-and-lease transaction. 6. A lease arrangement is sometimes, in substance, no more than , an instalment purchase of the property. This may well be the case when the lease is made subject to purchase of the property for a nominal sum or for an amount obviously much less than the prospec- tive fair value of the prOperty; or when the agreement stipulates that the rental payments may be applied in part as instalments on the 'purchase price; or when the rentals obviously are so out of line with rentals for similar properties as to negative the representation that the rental payments are for current use of the property and to create the presumption that portions of such rentals are partial payments under a purchase plan. 2The conventional lease, a straight tenure contract between the owner of property and a lessee, generally does not involve buying, building, and selling of property by the lessee, or special repurchase arrangements. 3Thrce years has been used as a criterion in some cases for classifying lc‘ short-term or long-term. ' 198 LongJum Leases l27 7' 7. Since the lessee in such cases does not have legal title to the prOperty and does not necessarily assume any direct mortgage obliga- tion, it has been argued that any balance sheet which included the property among the assets and any related indebtedness among the ion that the facts relating to all such leases should be carefully con- ...dered and that, where it is clearly evident that the transaction involved is in substance a purchase, the “leased” property should be included among the assets Hi the lessee with suitable accounting for the cor- responding liabilities and for the related charges in the income state- ment. One member of the committee, Mr. Lindquist, assented with qualification to adoption 0} chapter 14. Mr. Lindquist's qualification relates to paragraph 6. He believes that at any time during a long-term lease, other than a reasonable period before its expiration, no determination is possible as to prospective fair value of the pmperty for comparison with the purchase price that may be stated in the lease. He also questions the ability of an accountant to carry out the implicit requirement for comparison of the lease rental with rentals for similar properties in view of the many physical and other factors on which would rest a conclusion of similarity of properties. conch—G00 and?» 092.3 @0033 0» “on @3an a H3 me an“: on. twang «cegeoamm m3» mo mummy 9.3 amid encmmfiou 0am..— o» cupcakm mvufion 30G 33 .850 cannumo o» HMHENU >0. wouwfiw toy 3.2 0.3m «@033 6.393: mo Hm>oum .mm “305?? raumoam than mo memdoa Bo: OZ usagmgvv vcfioummo Coflufimwfiwqm 05 new 30.93. .50 $3... Refinance mo 8o .8; E can ,. .32 .8 $3. 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GHQ .00 000 00 0000>00 w00000000 000000 000 00 0000 0000000000 00300 00 0000000000000 0.>0000000 .000 00010 0000000000 .030 000 00 0000\m 0 0000000 000 >000 000 00 0000 0000 0000 00 0000>00 00000000000000 0000 0000000 030 0000m 00000 w000000 9000000003 000> >00 00000000 0000 0000 00 00000000000 0000000 0000 .omo0 .am >002 .080 00 >0000000 0000 00 000000>00 000000 0000000000000 w000000x0v 0000 00000.0 00 00000 000 .00 .000 0000000000 0000000000 000 0000> 030 0000 00000 00000000 000 00000 000000 0000000 0000 00 00>00000 000 00000000 00 00000 00 00000 0 000 000000 0000000000 00w000 000 0000003 0000 00 00 000 >000 0000 00000.0 3070 0000003 .N0000000 000 00 000000 00000 000 00 0000> 00000 000 00 000m 00 ooo .ooo .omw 00 000000 000 000 .25 .oom .NW 00 0000000 00 0000000 000000003 000000000 .. 000003 0000000000 000010 000000000000 000n0 0000000004 00 0000 000 .00000010 000000.40 000000000 . > 0300700004 2.06 APPENDIX VI LEASE THIS LEASE, made this ......... ...............dsy of . 19 ; by and between a California corporation, hereinafter called “lessor," and hereinafter called “lessee”, WITNESSETH: For and in consideration of the mutual covenants and promises hereinafter set forth, the parties hereto agree as follows: 1. Lease. Lessor hereby leases to lessee, and lessee hereby leases and hires from lessor all machinery, uipment and other roperty described in (a) the schedule executed by the arties concurrently herew: or hereafter an made.a part hereo . and (b) any schedule or schedules hereafter executed y the arties hereto and .made a lpart hereof. All said machinery, guipment and other property described in all said schedules is ereinafter collectively cal ed “equipment"; and all said sch ules are hereinafter collectively called “schedule”. 2. Term. The term of this lease respecting each item of equipment commences upon whicheverof the following dates is earlier: (al {Che date lessor confirms to the seller of said item of equipment the lessee’s purchase order for said item or; (b) The date said item of equipment is delivered to lessee. The term of this lease ends on the date designated in the schedule. 3. Rent. The rent for any and every item of equipment described in the schedule shall be the amount designated in the schedule. Lessee shall pay lessor said rent in advance, in the amounts and at the times set forth in the schedule, at the oilice of lessor, 580 California Street, San Francisco, Cuuiornia, or to such other person and/or at such other place as lessor may from time to time designate in writing. 4. Use. Lessee shall use the equipment in a careful and proper manner and shall comply with and conform to all national, state, municipal. police and other laws, ordinances and regulations in anywise relating to the possession, use or maintenance of the equi ment. If at any time during the term hereof lessor supplies lessee with labels, plates or other markings, stating that e equipment is owned by lessor, lessee shall affix and keep the same upon a prominent place on the equipment. 5. Lessee’s Inspection; Conclusive Presumptions. Lessee shall inspect the equipment within forty-eight (48) hours after receipt thereof. Unless lessee within said period of time gives written notice to lessor, specifying any defect in or other proper objection to the equipment, lessee agrees that it shall be conclusively presumed, as between lessor and lessee. that lessee has fully inspected and acknowledged that the equipment is in good condition and repair, and that lessee is satis- fied with and has accepted the equipment in such good condition and repair. 6. Lessor's Inspection. Lessor shall at any and all times during business hours have the right to enter into and upon the premises where the equipment may be located for the pu ose of inspecting the same or observing its use. Lessee shall give lessor immediate notice of any attachment or other judici process affecting any item of equipment and shall, whenever requested by lessor, advise lessor of the exact location of the equipment. 7. Alterations. Without the (Brior written consent of lessor, lessee shall not make any alterations, additions or im- rovements to the equipment. All ad 'tions and improvements of whatsoever kind or nature made to the equipment shall be- ong to and become the property of lessor upon the expiration, or earlier termination, of this lease. 8. Repairs. Lessee, at its own cost and expense. shall keep the uipment in good repair, condition and working order 8:3 shall furnish any and all parts, mechanisms and devices required to eep the equipment in good mechanical and working 0 er. 9. Loss and Damage; Sti ulated Loss Value. Lessee hereby assumes and shall bear the entire risk of loss and damage to the equipment from any an eve cause whatsoever. No loss or damage to the equipment or any part thereof shall im- pair any obligation of lessee under t is lease which shall continue in full force and effect. In the event of loss or damage of any kind whatever to any item of equipment, lessee at the option of lessor shall: (a) Place the same in good repair. condition and working order; or , (b)' Replace the same with like equipment in good repair, condition and working order; or, if same is determined by lessor to be lost, stolen, destroyed or damaged beyond repair. lessee shall: (c) Pay lessor therefor in cash the “Stipulated Loss Value” as set forth in the schedule. Upon such payment this lease shall terminate with respect to such item of equipment so paid for and lessee thereupon shall become entitled to such item of equipment as-is-where-is without warranty, express or implied, with respect to any matter whatsoever. 10. Surrender. Upon the expiration or earlier termination of this lease, with respect to any item of equipment, lessee shall (unless lessee has paid lessor in cash the “Stipulated Loss Value” of such item of equipment pursuant to paragraph 9 hereof) return the same to lessor in good repair, condition and working order, ordinary wear and tear resulting from proper use thereof alone excepted, in the following manner as may be specified by lessor: . (a) By delivering such item of equipment at lessee's cost and expense to such place as lessor shall specify within the city or county in which the same was delivered to lessee or to which same was moved with the written consent of lessor; . (b) By loading such item of equipment at lessee’s cost and expense on board such carrier as lessor shall specify and shmmng the same, freight collect, to the destination designated by lessor. [v O R1 11. Insurance. Lessee shall keep the equipment insured against all risks of loss or damage from every cause whatso- ever for not less than the full replacement value thereof as determined by lessor; and shall carry public liability and prop- erty damage insurance covering the equipment. All said insurance shall be in form and amount and with companies approved by lessor. and shall be in the joint names of lessor and lessee. Lessee shall pay the premiums therefor and deliver said policies, or duplicates thereof, to lessor. Each insurer shall agree, by endorsement upon the policy or policies issued by it or by independent instrument furnished to lessor, that it will give lessor thirty (30) days written notice before the policy in question shall be altered or cancelled. The proceeds of such insurance, at the option of lessor, shall be applied (a) toward the re lacement, restoration or repair of the equipment or (b) toward payment of the obligations of lessee hereunder. Lessee hereby appoints lessor as lessee's attorney-in-fact to make claim for, receive payment of, and execute and endorse all documents. checks or drafts for, loss or damage under any said insurance policy. 12. Taxes. Lessee shall keep the equipment free and clear of all levies, liens and encumbrances and shall pay all license fees, registration fees, assessments, charges and taxes (municipal, state and federal) which may now or hereafter be imposed upon the ownership, leasing, renting, sale, possession or use of the equipment. excluding, however, all taxes on or measured by lessor’s income. 13. Lessor’s Payment. In case of failure of lessee to procure or maintain said insurance or to pay said fees, assess- ments, charges and taxes, all as hereinbefore specified, lessor shall have the right, but shall not be ob igated, to effect such insurance, or pay said fees. assessments, charges and taxes. as the case may be. In that event, the cost thereof shall be repayable to lessor with the next installment of rent, and failure to repay the same shall carry with it the same consequence, including interest at seven per cent (7%) per annum. as failure to pay any installment of rent. ' 14. Warranties. Lessor makes no warranties, either express or implied, as to any matter whatsoever. including, with- out limitation, the condition of the equipment, its merchantability or its fitness for any particular purpose. 15. Indemnity. Lessee shall indemnify lessor against, and hold lessor harmless from, any and all claims, actions, suits, proceedings. costs, expenses, damages and liabilities, including attorney’s fees, arising out of, connected With, or resulting from the equipment, including Without limitation the manufacture, selection, delivery, possession, use, operation or return of the equipment. 16. Security. As security for the prompt and full payment of the rent, and the faithful and timely performance of all provisions of this lease, and any extension or renewal thereof, on its part to be performed, lessee has pledged and deposited with lesser the amount set forth in the schedule. In the event any default shall be made in the performance of any of the covenants on the part of lessee herein contained with respect to any item or items of equipment lessor shall have the right, but shall not be obligated, to apply said security to the curing of such default. Any such application by lessor shall not be a defense to any action by lessor arising out of said default; and, upon demand, lessee shall restore said security to the full amount set forth in the schedule. Upon the expiration, or earlier termination, of this lease, or any extension or renewal thereof, provided lessee has paid all of the rent herein called for and fully performed all of the other provisions of this lease on its part to be performed, lessor will return to lessee any then remaining balance of said security. 17. Default. If lessee with regard to any item or items of equi ment fails to pay any rent or other amount herein rovided within ten (10) da 3 after the same s. due and payable, or: lessee With regard to any item or items of equi ment ails to observe, keep or per cm any other provision of this lease requiredto be observed, kept or performed by lessee, essor shall have the right to exercise any one or more of the following remedies: a) To declare the entire amount of rent hereunder immediately due and payable as to any or all items of equip- ment. wit out notice or demand to lessee. (b) To sue for and recover all rents, and other payments, then accrued or thereafter accruing. with respect to any or all items of equipment. (c) To take possession of any or all items of equipment, without demand or notice, wherever same maybe located, without any court order or other process of law. Lessee hereby waives any and all damages occasioned by such taking of possession. Any said taking of possession shall not constitute a termination of this lease as to any or all items of equipment unless lessor expressly so notifies lessee in writing. (d) To terminate this lease as to any or all items of equipment. (e) To pursue any other remedy at law or in equity. Notwithstanding any said repossession, or any other action which lessor may take, lessee shall be and remain liable for the full performance of all obligations on the part of lessee to be performed under this lease. All such remedies are cumulative, and may be exercised concurrently or separately. 18. Bankruptcy. Neither this lease nor any interest therein is assignable or transferable by operation of law. If any proceeding under the Bankruptcy Act, as amended. is commenced by or against the lessee, or if the lessee is adjudged in- solvent, or if the lessee makes any assignment for the benefit of his creditors, or if a writ of attachment or execution is levied on any item or items of the equipment and is not released or satisfied within ten (10) days thereafter, or if a receiver is appointed in any proceeding or action to which the lessee is a party with authority to take possession or control of any item or items of the equipment, lessor shall have and may exercise any one or more of the remedies set forth in paragraph 17 hereof; and this lease shall, at the option of lesser, without notice. immediately terminate and shall not be treated as an asset of lessee after the exercise of said option. 19. Concurrent Remedies. No right or remed herein conferred upon or reserved to lesser is exclusive of any other right or remedy herein or by law or equity provide or permitted; but each shall be cumulative of every other right or remedy given ereunder or now or hereafter existing at law or in equity or by statute or otherwise, and may bevenforced concurrently therewith or from time to time. _ 20. Lessor’s Expenses. Lessee shall pay lessor all costs and expenses, including attorneys' fees, incurred by lessor in exercising any of its nghts or remedies hereunder or enforcing any of the terms, conditions, or provisions hereof. 21. Assignment. Without the prior written consent of lesser, lessee shall not (a) assign, transfer, pledge or hypothe- cate this lease. the equipment or any part thereof, or any interest therein or (b) sublet or lend the equipment or any part thereof, or ermit the equipment or any part thereof to be used by anyone other than lessee or lessee's em loyees. Consent to any of t e foregoing prohibited acts applies only in the given instance; and is not a consent to any su sequent like act by lessee or any other person. Subject always to the foregoing, this lease inures to the benefit of, and is binding upon, the heirs, legatees, personal representatives, successorsand assigns_o_f__thgparties hereto. [\J 0 0C 22. Lessor’s Assignment. It is understood that lessor contemplates assigning this lease and/or mortgaging the equip- ment, and that said assignce may assign the same. All rights of lessor hereunder may be assigned. pledged, mortgaged, transferred, or otherwise disposed of, either in whole or in part, without notice to lessee. If lessor'aSSigns this lease or the rentals due or to become due hereunder or any other interest herein, whether as security for any of its indebtedness or other- wise, no breach or default by lessor hereunder or pursuant to any other agreement between lesser or lessee, should there he one, shall excuse performance by lessee of any provision hereof. No such assignee shall be obligated to perform any duty, covenant or condition required to be performed by lessor under the terms of this lease. 23. Ownership. The equipment is. and shall at all times be and remain, the sole and exclusive property of lesser; and the lessee shall have no right, title or interest therein or thereto except as expressly Set forth in this lease. 24. Personal Property. The equipment is, and shall at all times be and remain, personal property notwithstanding that the equipment or any part thereof may now be, or hereafter become, in any manner affixed or attached to. or imbed- ded in, or permanently resting upon. real property or any building thereon, or attached in any manner to what is perman- ent as by means of cement, plaster, nails, bolts, screws or otherwise. , 25. Interest. Should lessee fail to pay any part of the rent herein reserved or any other sum required by lessee to be paid to lesser. within ten (10) days after the due date thereof. lessee shall pay unto the lessor interest on such delinquent pay- ment from the expiration of said ten (10) days until paid at the rate of seven per cent (7%) per annum. 26. Offset. Lessee hereby waives any and all existing and future claims. and offsets, against any rent or other pay- ments due hereunder; and agrees to pay the rent and other amounts hereunder regardless of any offset or claim which may be asserted by lessee or on its behalf. 27. Non Waiver. No covenant or condition of this lease can be waived except by the written consent of lessor. For- bearance or indulgence by lessor in any regard whatsoever shall not constitute a waiver of the covenant or condition to be performed by lessee to which the same may apply, and, until complete performance by lessee of said covenant or condition. lessor shall be entitled to invoke any remedy available to lesser under this lease or by law or in equity despite said for- bearance or indulgence. 28. Entire Agreement. This instrument constitutes the entire agreement between lessor and lessee; and it shall not be amended, altered or changed except by a written agreement signed by the parties hereto. ‘ 29. Notices. Service of all notices under this agreement shall be sufficient if given personally or mailed to the party involved at its respective address hereinafter set forth, or at such address as such party may provide in writing from time to time. Any such notice mailed to such address shall be effective when deposited in the United States mad, duly addressed and with postage prepaid. . 30. Genders Number. Whenever the context of this lease requires, the masculine gender includes the feminine or neuter, and the Singular number includes the plural; and whenever the word “lessor” is used herein, it shall include all asmgnees of lesser. If there is more than one lessee named in this lease, the liability of each shall be joint and several. . 31. Titles. The titles to the paragraphs of this lease are solely for the convenience of the parties, and are not an aid in the interpretation of the instrument. 32. Tm». Time is of the essence of this lease and each and all of its provisions. IN WITNESS WHEREOF the parties hereto have executed these presents the day and year first above written. B ..... By ....... Title Title By . By Title Title Lessor Lessee (Seal) (Seal) Courtesy of United States Leasing Corporation 580 California Street. San Francisco 4 California Addr-