Issue 1: Capital vs. Operating Determination

FAS 13 paragraph 7: “Criteria for Classifying Leases (Other Than Leveraged
Leases)”
o The criteria for classifying leases set forth in this paragraph and in paragraph
8 derive from the concept set forth in paragraph 60. If at its inception (as
defined in paragraph 5(b)) a lease meets one or more of the following four
criteria, the lease shall be classified as a capital lease by the lessee.
Otherwise, it shall be classified as an operating lease. (See Appendix C for an
illustration of the application of these criteria.)
o a. The lease transfers ownership of the property to the lessee by the end of
the lease term (as defined in paragraph 5(f)). 10a None of the Leases
o b. The lease contains a bargain purchase option (as defined in paragraph
5(d)). None of the Leases
o c. The lease term (as defined in paragraph 5(f)) is equal to 75 percent or
more of the estimated economic life of the leased property (as defined in
paragraph 5(g)). However, if the beginning of the lease term falls within the
last 25 percent of the total estimated economic life of the leased property,
including earlier years of use, this criterion shall not be used for purposes of
classifying the lease. None of the Leases as useful life is 40 years *75% =
30 years and no lease terms in excess of 23.
o d. The present value at the beginning of the lease term of the minimum lease
payments (as defined in paragraph 5(j)), excluding that portion of the
payments representing executory costs such as insurance, maintenance, and
taxes to be paid by the lessor, including any profit thereon, equals or exceeds
90 percent of the excess of the fair value of the leased property (as defined in
paragraph 5(c)) to the lessor at the inception of the lease over any related
investment tax credit retained by the lessor and expected to be realized by
him. However, if the beginning of the lease term falls within the last 25
percent of the total estimated economic life of the leased property, including
earlier years of use, this criterion shall not be used for purposes of classifying
the lease. A lessor shall compute the present value of the minimum lease
payments using the interest rate implicit in the lease (as defined in paragraph
5(k)). A lessee shall compute the present value of the minimum lease
payments using his incremental borrowing rate (as defined in paragraph 5(1)),
unless (i) it is practicable for him to learn the implicit rate computed by the
lessor and (ii) the implicit rate computed by the lessor is less than the lessee's
incremental borrowing rate. If both of those conditions are met, the lessee
shall use the implicit rate. 2 Leases meet this classification (Manhattan
and Lincoln).

FAS 13 paragraph 26: “Leases Involving Land and Building(s)”
o 26. Leases involving both land and building(s) shall be accounted for as
follows:

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ii. If the fair value of the land is 25 percent or more (all cases) of the
total fair value of the leased property at the inception of the lease:
Both the lessee and lessor shall consider the land and the building
separately for purposes of applying the criteria of paragraphs 7(c) and
7(d). The minimum lease payments after deducting executory costs,
including any profit thereon, applicable to the land and the building
shall be separated both by the lessee and the lessor by determining
the fair value of the land and applying the lessee's incremental
borrowing rate to it to determine the annual minimum lease payments
applicable to the land element; the remaining minimum lease
payments shall be attributed to the building element. (Must bifurcate
the land and building portion treating land as an operating lease
and building as a capital lease if it meets capital lease treatment
criteria on its own)
FAS13 paragraph 28 “Leases Involving Only Part of a Building”
o When the leased property is part of a larger whole, its cost (or carrying
amount) and fair value may not be objectively determinable, as for example,
when an office or floor of a building is leased. If the cost and fair value of the
leased property are objectively determinable, both the lessee and the lessor
shall classify and account for the lease according to the provisions of
paragraph 26. Unless both the cost and the fair value are objectively
determinable, the lease shall be classified and accounted for as follows:
o Lessor: If either the cost or the fair value of the property is not objectively
determinable, the lessor shall account for the lease as an operating lease. (In
case I indicated FMV of partial building lease was not determinable so no
capital analysis other than 75% of life, ownership transfer and bpo
necessary) This is the case for the Lawrence property.
Issue 2: Definition of Lease Term

FAS13 paragraph 5: “Definition of Terms”
o Lease Term. The fixed noncancelable term of the lease plus (i) all periods, if
any, covered by bargain renewal options (as defined in paragraph 5(e)), (ii) all
periods, if any, for which failure to renew the lease imposes a penalty (as
defined in paragraph 5(o)) on the lessee in such amount that a renewal
appears, at the inception of the lease, to be reasonably assured, (this is
key; in case I spelled out that renewal would be reasonably assured up
to 18 years based on George’s business model) What this does is
includes the option periods in what is now defined as the lease term
where before only the base lease term with no options was considered.
By including this it makes the company straight-line the lease expense
for operating leases and reanalyze the capital vs. operating treatment as
they now have a longer term with more payments to consider for the
90% test.(iii) all periods, if any, covered by ordinary renewal options during
which a guarantee by the lessee of the lessor's debt directly or indirectly
related to the leased property 2a is expected to be in effect or a loan from the
lessee to the lessor directly or indirectly related to the leased property is
expected to be outstanding, (iv) all periods, if any, covered by ordinary
renewal options preceding the date as of which a bargain purchase option (as
defined in paragraph 5(d)) is exercisable, and (v) all periods, if any,
representing renewals or extensions of the lease at the lessor's option;
however, in no case shall the lease term be assumed to extend beyond the
date a bargain purchase option becomes exercisable. A lease that is
cancelable (a) only upon the occurrence of some remote contingency, (b) only
with the permission of the lessor, (c) only if the lessee enters into a new lease
with the same lessor, or (d) only if the lessee incurs a penalty in such amount
that continuation of the lease appears, at inception, reasonably assured shall
be considered "noncancelable" for purposes of this definition.
o Penalty. Any requirement that is imposed or can be imposed on the lessee
by the lease agreement or by factors outside the lease agreement to disburse
cash, incur or assume a liability, perform services, surrender or transfer an
asset or rights to an asset or otherwise forego an economic benefit, or suffer
an economic detriment. Factors to consider when determining if an economic
detriment may be incurred include, but are not limited to, the uniqueness of
purpose or location of the property, the availability of a comparable
replacement property, the relative importance or significance of the property to
the continuation of the lessee's line of business or service to its customers, the
existence of leasehold improvements or other assets whose value would be
impaired by the lessee vacating or discontinuing use of the leased property,
adverse tax consequences, and the ability or willingness of the lessee to bear
the cost associated with relocation or replacement of the leased property at
market rental rates or to tolerate other parties using the leased property. In
practice this is more judgmental but I basically told them in the case
there is an economic penalty to George’s for not renewing up to at least
18 years.
Issue 3: Step Rent vs Straight Line

FAS13 paragraph 15 “Operating Expenses”
o Normally, rental on an operating lease shall be charged to expense over the
lease term as it becomes payable. If rental payments are not made on a
straight-line basis, rental expense nevertheless shall be recognized on a
straight-line basis unless another systematic and rational basis is more
representative of the time pattern in which use benefit is derived from the
leased property, in which case that basis shall be used.
Issue 4: Depreciation of Leasehold Improvements

FAS13 - Leasehold improvements must be amortized over the shorter of the remaining
lease term or the economic useful life of the asset. For leasehold improvements the
estimated useful life is 20 years. In the past George’s had been depreciating all
improvements over 20 years. By applying the lease term rules it dropped two of
the leases to 19 year terms. As such depreciation had to be accelerated and the
students were to calculate the cumulative catch up necessary. For the other 3
lease terms that were 20 years or greater, no catch-up was necessary as already
being depreciated over the shorter of economic life or lease term.
Note: For the two land and building leases that broke the 90% test students were
to compute the entries to capitalize the buildings only (not land portion of the
lease) and depreciate them. To do this was simply reversal of rent expense and
record interest and depreciation expense on the building. Also capitalize asset
and record lease obligation.