Sam Gray, the CEO of Steele Corporation, was meeting with the company controller to discuss a possible major lease of a new production facility. Steele Corporation had a large amount of debt, and Sam was concerned that adding more debt to acquire the production facility would worry the shareholders. Sam knew that if the production facility could be classified as an operating lease rather than a capital lease, the lease obligation would not have to be reported on the balance sheet. Thus, the company could have a new production facility without having to report any additional debt. The accountant told Sam that if the title to the production facility transferred automatically to Steele at the end of the lease term, then the lease would have to be classified as a capital lease. Also, if the lease had a bargain purchase option, such that Steele Corporation could simply purchase the facility at the end of the lease term for a small option amount, it would also be classified as a capital lease. Sam said not to worry because he would make sure that the lease contract would not contain any title transfer or bargain purchase option. The accountant then said that the facility had a 20-year life and the lease was for 16 years, which was more than 75% of the economic life of the asset, so it would have to be classified as a capital lease. Sam then said he would change the lease term to 14 years so the lease term would be less than the 75% of the economic life of the facility. The accountant then computed the present value of all the lease payments, and the total was more than 90% of the market value of the facility. Again, Sam said he would make any needed changes so that the total present value of the lease payments would be 89% of the current market value of the facility. At this point the accountant became frustrated and told Sam that the rules of accounting used to determine the proper classification of a lease were not meant to be used to misclassify a leased asset and, thereby, provide misleading information. Sam then said the rules simply served as a guide for structuring the lease and that he was merely using the rules to allow the lease to be classified as an operating lease and, thus, the lease obligation would not have to be recorded. The accountant said that intentionally avoiding the rules was unethical and wrong.
Requirements
1. Why does Sam want to have the lease classified as an operating lease rather than a capital lease?
2. Does the accountant have a legitimate argument? Does Sam have a legitimate argument?
3. What ethical issues are involved?
4. Do you have any other thoughts?