This paper analyzes the accounting distinctions between operating leases, capital leases, and sales-type leases, focusing on how IBM exploited FASB regulations to reclassify leases and bolster short-term profits. The paper explains the revenue recognition differences between lease types, then details how IBM used "7D insurance" purchased from Merrill Lynch to artificially meet the 90% fair market value threshold required under FASB paragraph 7D. It further examines how the party responsible for paying the insurance premium determines whether a lease should be classified as a capital or operating lease, and includes a numerical example illustrating the 90% FMV test with and without the guaranteed residual value.
Some leases are classified as capital leases because the conditions set down in the lease provide for a transfer of ownership at the conclusion of the agreement. This transfer is either automatic, or the lessee is provided with an option to buy the equipment at a reduced price after the term of the lease has expired. If ownership of the asset or equipment is to be retained by the lessor at the conclusion of the lease, then the lease is properly classified as an operating lease. A sales-type lease is a particular type of capital lease that involves the leasing of equipment manufactured and/or distributed by the lessor company.
A lessor can profit by having an operating lease classified as a capital lease because of the difference in accounting regulations governing the two types. Operating leases are recorded as profit as the actual payments are received. Capital leases, on the other hand, list all revenue to be generated by the lease in the first year, regardless of the actual life of the lease.
For example, imagine a person leases a car for two years at $300 per month. If the lease is classified as an operating lease, the lessor would record revenues as they are received — $300 per month. If the lease were classified as a capital lease, then the total amount of the lease (24 months × $300 = $7,200) would be listed in the first year. This has the effect of bolstering profits in the short term but runs the risk of long-term reductions in reported profit.
IBM used this aggressive accounting technique to bolster its own profits. The Financial Accounting Standards Board (FASB) has regulations designed to prevent companies from abusing this method. According to FASB standards, one of several conditions must be met in order for a lease to be classified as a sales-type lease. IBM focused on a formula presented in paragraph 7D of the regulations: total the amount of the lease payments, then add to this amount the value of the equipment at the end of the lease. If this figure is 90% or more of the equipment's fair market value today, then the lease can be classified as a sales-type lease.
However, IBM was falling short of the 90% margin and therefore should not have been able to list its operating leases as sales-type leases. To counter this, IBM purchased "7D insurance" from Merrill Lynch. By buying this insurance, IBM received a guarantee of a certain value for its computers at the expiration of the lease, which kept IBM above the 90% threshold and allowed it to continue listing its leases as sales-type leases.
In the example provided, IBM insured a computer to guarantee a minimum value of $250,000. Added to the total of all lease payments ($600,000), this yields $850,000 — which IBM maintained was the fair market value of the computer. Without the insurance, IBM would receive the machine back with a residual value of zero dollars, leaving only the total lease payments of $600,000 as a contributing factor — well below the 90% mark.
"IBM paying shifts lease to operating classification"
"Lessee paying shifts lease to capital classification"
"Figure 1 shows 90% FMV test calculations"
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