Statement No. 13, issued in November 1976, along with the myriad amendments and interpretations, governs the accounting for lessees. The statement invents two classes, capital leases and operating leases. In a capital lease, the firm capitalizes the asset at its present value (not to exceed its fair value), it capitalizes the lease obligation at the present value of future cash flows, and it displays the depreciation of the capitalized asset and the interest expense on the lease obligation. In an operating lease, the entity ignores its property rights and its debts; the only thing it does is to book rent expense.

Sophisticated users have adjusted for this theater of the absurd by performing analytical adjustments or reverse engineering. Employing the data available to them, these users undo the effects of the operating leases and then estimate the effects of the capital leases. The differences can be enormous. Let's illustrate these variances by adjusting the numbers for Starbucks.

This adjustment process consists of seven steps:

• Find the lease cash payments.
• Choose an appropriate rate of interest.
• Compute the leased assets and the lease obligations as the present value of the future cash payments.
• Estimate the life of the leased assets and their current age. With these assumptions, calculate depreciation expense and accumulated depreciation.
• Estimate the interest expense.
• Estimate the change in income taxes and deferred income taxes.
• With these adjustments, prepare the adjusted income statement and the adjusted balance sheet.

I followed this process for Starbucks' financial statements dated October 2, 2005. I obtain the following results (dollar amounts in thousands of dollars).

	Reported	Adjusted	%change
Current assets	$ 1,209,334	$ 1,209,334	0%
Long-term assets	2,304,731	4,426,992	92%
Total Assets	3,514,065	5,636,326	60%
Current Debts	1,226,996	1,630,390	33%
Long-term debts	196,435	2,393,341	1118%
Stockholders Equity	2,090,634	1,612,595	(23)%
Total Equities	3,514,065	5,636,326	60%
Net income	494,467	686,722	39%

The two methods generate the same expenses over the life of the lease, though they create different year-to-year effects. Capitalization of the leases has a felicitous income effect for Starbucks in 2005, for the removal of rent expense swamps the effect of increasing the depreciation expense and the interest expense.

The major effects occur on the balance sheet. The long-term assets almost double with the capitalization of these leases, the current liabilities increase by almost a third, while the long-term debts explode with an increase of over one-thousand percent! Notice that Starbucks has $2 billion in debt that it doesn't report!

In terms of some popular ratios, Starbucks' current ratio would drop from 0.99 to 0.74, its return on assets would decline from 0.14 to 0.12, and the debt-to-equity ratio more than triples from 0.68 to 2.49. Clearly, Starbucks is leveraged more greatly than it admits.

Sophisticated investors can perform these adjustments and obtain a clearer vision of the entity's future than it would by naively analyzing the reported numbers. While sophisticated users can do this, it does not excuse FASB's inertia to change its lease pronouncements. The process is costly and involves estimation errors; unsophisticated users might be hurt by their inability to adjust reported numbers adequately; and contracts might employ reported numbers, thereby biasing the relationship among the various parties to the contract. The better policy is for FASB to get off its collective back-side and correct the mistakes in Statement No. 13.

While the problem rests primarily with FASB -- and the Securities and Exchange Commission for its failure to pressure FASB to improve lease accounting -- managers could report all leases as if they were capital leases. That is, if corporate managers cared about reporting accounting truth about the business enterprise instead of merely complying with the rules.