When is a lease a capital idea? Laurie Gocker, Inc., entered into a lease arrangement with Nathan Morgan Leasing Corporation for an industrial machine. Morgan’s primary business is leasing. The cash purchase price of the machine is $1,000,000. Its economic life is six years. Gocker’s balance sheet
 reflects total assets of $10 million and total liabilities of $7.5 million. Among the liabilities is a $2.5 million long-term note outstanding at Last National Bank. The note carries a restrictive covenant that requires the company’s debt ratio to be no higher than 75%. The company’s revenues have been falling of late and the shareholders are concerned about profitability.
Gocker and Morgan are engaging in negotiations for terms of the lease. Some other relevant facts are as follows:
1. Morgan wants to take possession of the machine at the end of the initial lease term.
2. The term may run from four to five years, at Gocker’s discretion.
3. Morgan estimates the machine will have no residual value, and Gocker will not purchase it at the end of the lease term.
4. The present value of minimum lease payments on the machine is $890,000.

Requirements
1. What is (are) the ethical issue(s) in this case?
2. Who are the stakeholders? Analyze the consequences for each stakeholder from the following standpoints:
(a) Economic,
(b) Legal,
(c) Ethical.
3. How should Gocker structure the lease agreement?
4. As of the date of this text, the FASB and IASB have issued a joint exposure draft of a new standard on long-term leases that will require companies to capitalize most leases like this one. How will the analysis of this case change when this standard is issued?
 

Req. 1

A company would prefer not to disclose its contingent liabilities because they cast a shadow on the business and create a negative impression.

Req. 2 and 3

The potential parties and economic consequences of the decision not to disclose contingent liabilities are:

1. The bank and its shareholders: With misleading information, they might extend additional funds to the borrower assuming a better ability to pay back the funds than actually exists. A contingent liability creates risk for a company. If the contingent liability is not reported, the bank may view the company as low-risk. This may lead the bank to loan money at low interest rates and with easy payment terms. With knowledge of the contingent liability, the bank might not have made the loan at all. Or the bank might have required a higher interest rate or more stringent payment terms. Making loans on too-easy terms robs the bank's owners of their money.

2. The company seeking the loan: Might become overextended in its borrowing and risk default on debt in the future.

3. Microsoft stockholders.

4. Parties to the lawsuit.

Req. 3 Legal and ethical consequences

Banks have legal requirements in loan agreements that require debtors to maintain certain ratios of assets and liabilities on their books or risk default. Failure of a company to report its contingent liabilities to a bank requesting this disclosure could subject the company to a lawsuit later on.

From an ethical standpoint, reporting a contingent liability requires a delicate balancing act. Ethics require that outsiders' interests be protected. The company must disclose enough information to give outsiders a reasonable basis for making informed decisions about the company. At the same time, the company should avoid giving away secrets that could damage its owners' investment in the business. This dilemma is clear when a defendant fears losing an important lawsuit. Fortunately for accountants, most companies settle out of court those lawsuits that they expect to lose. In such cases, there are no contingent liabilities to disclose.

Req. 4

The FASB and IASB about a new standard for reporting contingencies. It is likely that, in the future, more losses resulting from lawsuits and other contingencies are likely to be disclosed in the body and the footnotes of financial statements.