You are the accountant for Clear Water Bay Company, an equipment manufacturer. In order to help customers finance their purchases, Clear Water Bay often leases, rather than sells, the equipment. Clear Water Bay structures the lease agreements so that most of its equipment leases are classified as operating leases. This is because customers strongly prefer this treatment in order to keep the lease obligations off their balance sheets. This treatment does result in a delay in Clear Water Bay’s ability to report profits from the sales, but this delay has been viewed as part of the cost of keeping customers happy.
The president of Clear Water Bay just returned from a week-long accounting and finance seminar at a prominent university. She is excited about the session she attended on the accounting for leases. She was told, or thinks she was told, that there is no need for Clear Water Bay to report its leasing arrangements as operating leases—according to U.S. GAAP, lessors can always classify a lease as a sales-type lease even when the lessee classifies the same lease as an operating lease. The president tells you to get to work restating Clear Water Bay’s most recent financial statements to reflect reclassification of all Clear Water Bay’s leases from operating leases to sales-type leases.
Write a memo to the president clarifying the accounting rules governing sales-type and operating leases. Carefully explain the circumstances in which the same lease can be classified as a sales-type lease by the lessor and an operating lease by the lessee.