On May 10, the Financial Accounting Standards Board and the International Accounting Standards Board issued revised exposure drafts calling for significant changes in lease accounting. These drafts would eliminate the fiction of operating leases, requiring business entities to recognize the lease obligations and the leased resources on their balance sheets, along with the concomitant changes in the income statements and the cash flow statements.

These alterations are absolutely necessary, as an analysis of drug retailers and pharmacy chain CVS Caremark demonstrates. Under the present accounting standards, CVS Caremark can legally hide billions of dollars of liabilities and thereby vastly understate its financial leverage and its financial risk. Transparency and fair disclosure demand an amendment to present-day accounting rules, and this exposure draft goes a long way to improving financial reporting.

 

A LONG TIME COMING

The accounting profession has struggled with leases for decades, especially the standards-setting agencies. Not that the issues are particularly hard, but the political battle has been and remains intense.

Conceptually, liabilities are obligations of an entity that arise from past transactions or events. They are settled usually by the transfer or use of assets. Lease obligations fit this definition very well - they arise because the entity engages in a lease transaction with a lessor and they require settlement, usually by cash payments. As such, lease obligations should be displayed on corporate balance sheets. They are liabilities!

However, FASB has little power. Sometimes it has the support of the Securities and Exchange Commission, but for some odd reason the SEC has not bolstered FASB with respect to proper lease accounting. And Congress and the White House are often adversarial with FASB because they owe so much to corporate donors. Congress and the White House will only support FASB when it is advantageous to do so -- e.g., when there was a huge public outcry about Enron in 2001, and over the 2008 financial crisis.

It took a long time before FASB issued Statement No. 13 in 1976, which was the first and only standard that significantly increased the recognition of leased assets and lease debts. Even so, FASB invented an out for corporate America when it created two classes of leases, capital leases and operating leases.

If a lease is deemed to be a capital lease, the business enterprise records an asset and an obligation for the leased property equal to the present value of the future cash flows specified in the lease agreement (not to exceed its fair value).

They also compute and recognize depreciation on the capitalized asset; they account for the lease obligation similar to a mortgage or a bond, recognizing interest expense on the lease obligation.

In contrast, the class of operating leases allows corporate America to fib about its fixed obligations. The only thing they do in the accounts is to book rent expense. Operating leases obfuscate economic reality as real obligations exist that bypass the balance sheet.

Consider CVS Caremark, which has billions of dollars as operating leases. By estimating the effects of capitalizing these leases, one can obtain a picture of what a more transparent balance sheet looks like.

Practitioners have many algorithms to employ for reverse-engineering these operating leases. I carried out this adjustment process by employing the following steps:

  • Find the lease cash payments (a required disclosure per Statement No. 13).
  • 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 obtained the accompanying results for fiscal 2012 for CVS Caremark (reported and adjusted amounts in millions of dollars) (see "A prescription for change" here).

 

THE RESULTS

The net income effect can be an increase, a decrease, or no effect. The two methods generate the same expenses over the life of the lease, though the year-to-year effects differ.

To adjust the reported income effect for the capitalization of the operating leases, one takes off the rental expense but subtracts out the interest and depreciation expenses, adjusting these changes for tax effects. In this case, there is a small decline in net income.

Current assets are not affected by the capitalization of these operating leases, though it affects property, plant and equipment because it adds in the leased assets. In 2012, the impact of this capitalization is to add $11.7 billion to property, plant and equipment.

Current debts increase because of the present value of the lease payments during the next year. I estimate this to be $2.1 billion, so current liabilities increase by 16 percent in 2012.

Long-term debts increase because of the present value of lease payments made, except for those in 2013. This capitalization increases long-term liabilities by $17.3 billion. That's an increase of 121 percent over the reported number!

Stockholders' equity changes because of the estimated income effects in prior years. This requires an analysis of rental expense, interest expense, depreciation and income tax expense for past years.

I estimate that stockholders' equity would be smaller by $7.8 billion, or a decline of 21 percent from the reported measure.

Interestingly, the cash flow statement will generally improve after one moves from operating leases to capital leases.

This results because the operating lease method treats lease payments as operating cash flows, while the capital lease method breaks lease payments into interest cash flows and payments to reduce the lease obligation. The first are operating cash flows, the latter financing cash flows.

These account alterations impact widely used financial ratios, especially the financial leverage ratios. Reported numbers yield a debt-to-equity measure of 0.74. Employing the more economically realistic numbers, the debt-to-equity ratio becomes 1.60. Quite a difference!

Sophisticated investors and rating agencies perform these adjustments to obtain a clearer vision of the entity's future than presented by the reported numbers. While sophisticated users can do this, there are always assumptions that are made. The estimates are correct only to the extent that the assumptions are on target.

It would be better if business enterprises reported these lease effects correctly and if auditors attested them, so I hope that both FASB and the IASB continue to press this issue. Economic truth needs to be reported to the investment community, rather than be covered up.

 

J. Edward Ketz is an associate professor of accounting at Penn State. This essay reflects the author’s opinion, not necessarily the opinion of the Pennsylvania State University.

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