Hiding an Obligation By Calling It a Lease
You and your partner own Miss Karma’s Preschool, which provides preschool and day care
services for about 100 children per day. Business is booming, and you are right in the middle
of expanding your operation. Three months ago you took your financial statements to
the local bank and applied for a five-year, $145,000 loan. The bank approved the loan, but it
included as part of the loan agreement a condition that you would incur no other long-term
liabilities during the five-year loan period. You cheerfully agreed to this condition because
you didn’t anticipate any further financing needs.
Two weeks ago a state government inspector came to your facility and said that your
square footage was not enough for the number of children enrolled in your programs. The
inspector gave you one month to find another facility, or else you would have to shut down.
Luckily, you were able to find another building to use. However, the owner of the building
insists on having you sign a 20-year lease. Alternatively, you can buy the building for
$220,000. To buy the building, you would have to get a mortgage, which would, of course,
violate the agreement on your five-year bank loan.
Your partner suggests that the lease is the way to solve all of your problems. Your partner
has studied some accounting and reports that you can sign the lease but carefully construct
the lease contract so that the lease will be accounted for as an operating lease. In this
way, the lease obligation will not be reported as an accounting liability, the loan agreement
will not be violated, and you can move to the new facility without any problem.
Is your partner right? Is it possible to avoid reporting the 20-year lease contract as an accounting
liability? By signing the lease, are you violating the bank loan agreement? What do
you think is the best course of action?