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Lessor Problems

Can large software financings be structured to allow for off-balance-sheet treatment under FAS 13? JP Morgan Chase's Joe Sebik responds.

Q: As initially written, Financial Accounting Standard 13 excluded many intangibles, including software. However, with SOP 98-1, software has been reclassified as an asset, and one that must be (if material) capitalized upon acquisition.

What are your thoughts about structuring large software financings under FAS 13 to allow for off-balance-sheet treatment?

Ann Flynn
San Bruno, Calif.

Let us first say that regardless of how the following answer may come out, the answer included herein is the opinion of the writer and not of the company he works for or of the organization to which he is affiliated, or, for that matter, of CFO.com. With that disclaimer, we can speak freely about the background of software leasing and the applicability of it relative to capitalization of software.

I would say that not only can software be leased, but that software can be leased under an operating lease. However, accountants should exercise caution when examining a software lease and consider the reasons why a lessor would write such a lease and whether these reasons provide the accountant with reasons to classify the lease as a capital lease.

The preface of FAS 13 defines a lease as “an agreement conveying the right to use property, plant or equipment (land or depreciable assets or both) usually for a stated period of time.”

FAS 13 was meant primarily as an economic depiction of the substantial risks of ownership. Basically a lessee was to record as an asset anything which they had substantial risks of ownership, as defined in paragraph 7:

  • The lease does not transfer ownership at the end,
  • The lease is for less than 75%of the economic useful life of the asset,
  • The lease does not contain a bargain purchase option such that purchase of the asset is reasonably assured, and
  • The present value of the minimum lease payments is less than 90% of the fair market value of the asset.

This raises several important questions:

Can software be considered an asset which can be ‘leased’?

While software was not so widely considered at the time the original FAS 13 was written, the nature of what constitutes an asset has changed over the years, hence the idea that software costs can be capitalized as a fixed asset and depreciated over time, because its value is recoverable and useable over an extended period. Under the ‘matching principle’, we attempt to match revenues with the expenses incurred to generate or support the generation of those revenues. Hence, current accounting opinion has concluded that much software falls under the category of an asset that can be capitalized and depreciated.

Hence, I would conclude that software can be leased, subject to the other conceptual rules and guidelines of FAS 13.

Does a lessor maintain the ‘right to use’ the asset which can be conveyed to a lessee?

The right to use an asset was generally considered to exist because a company had the legal title to the asset and thus legally could restrict the use of the asset or provide for the right to use the asset. FAS 13 actually redefined this concept into an economic structure — that is, the right to use an asset can be defined in economic terms rather than legal terms which hinged on title and ownership.


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