In July, the Financial Accounting Standards Board announced that its agenda now includes a major project on lease accounting. As justification, the board cited encouragement from its own advisory councils and the Securities and Exchange Commission staff, all of which apparently concurred that "current lease standards fail to provide complete and transparent information."The announcement also stated that "lease arrangements have evolved considerably over the past 30 years and the standards are outdated." We're tempted to say, "Well, duh!" but we won't because of our great satisfaction that the board is preparing to throw out this example of WYWAP (Whatever You Want Accounting Principles) and POOP (Pitifully Old and Obsolete Principles).
This move did not come out of the blue. Indeed, the board (and its international counterparts) has been sending signals for a decade or more to the effect that the old principles are bad and need to be replaced by new ones that call for capitalizing all material leases.
Although SFAS 13 was supposed to force leases to be capitalized, the four "bright-line" classification criteria really served as nothing but comfort for auditors and guidelines for helping managers craft operating leases. As we show below, most evaluations of current lease accounting focus on the obvious flaw that it allows off-balance-sheet financing.
While that point is undeniable, it misses other failings. For one, misclassifying leases affects income and cash flow statements, too. For another, it has encouraged managers to engage in uneconomic transactions to produce deceptive reports, based on the faulty concept that statement users don't try to unwind bad accounting.
The outcome has been a black eye for the accounting, auditing and management professions, and a large dose of inefficiency in the capital markets. So, yes, reformation is long overdue.
The two myths
It seems to us that people have pooh-poohed the need for reform on the basis of two myths. The first is that investors already have enough information in the footnotes to produce modified financial statements. Well, it just isn't so, because the only numbers reported about these leases merely describe the gross cash flows expected over each of the next five years and beyond. While those amounts can be used to estimate the liability's value, the aggregation and lack of detail make the results highly uncertain and otherwise unreliable.
More important, those numbers do not allow statement users to estimate the asset value that's missing from the balance sheet. They can no more come up with that number than someone could estimate the value of your house using your mortgage balance. Also, the footnote doesn't provide useful clues on how much depreciation and interest cost would have been reported under capitalization.
The outcome is that the footnote is better than nothing, but not much. Apart from that point, why would it be good public policy to force users to produce their own estimates of numbers that managers should know and report?
The second myth is that capitalizing all leases would impact only the balance sheet. That nonsense is explained below.
Universal capitalization will surely bring previously unreported assets and liabilities onto balance sheets. (As a measure of scale, David Zion of Credit Suisse First Boston estimates that the S&P 500 companies have a combined off-balance-sheet operating lease liability of around $400 billion).
It follows that reported debt/equity ratios will go up as the new accounting reveals that which had previously been concealed. Of course, assets will also be recognized, thereby tending to lower the reported return on assets. (Whether it does so depends on what happens to reported income, as described in the next section.) The bottom line is that reformation will make many companies look worse, but that's OK because it will make them look more like they really are.
Operating lease accounting recognizes the lessee's payments as rent expense on the income statement. However, this number is really an aggregation of interest expense and cost-based asset depreciation. Under the usual system, rent is considered to be a regular operating expense and is deducted in arriving at operating earnings and earnings before interest, tax, depreciation and amortization.
But, under capitalization, only the depreciation component would be deducted from operating earnings, so that net number would tend to go up. Notice that reported EBITDA will increase by the full amount of today's reported rent expense. Thus, reform will produce a balance sheet that looks worse, while providing an income statement that tends to look better.
Furthermore, capitalization will produce a different pattern of reported expense over a lease's life, because the cost-based depreciation is likely to be constant from year to year, while the amount of interest will start high and trend lower as the liability balance declines.
Less obvious, perhaps, are the impacts on the cash-flow statement. Under current practice, the amount of rent expense is roughly equal to the cash paid by the lessee. Thus, net income is not modified in estimating operating cash flow.
However, if lease costs are disaggregated into interest and depreciation, the latter will be added back to reported net income (under the indirect method) and produce a larger reported measure of cash from operations. In addition, disaggregating operating lease payments into interest and principal will cause the latter to appear among the financing uses of cash.
Although the combined cash flow is unchanged, there will be a net increase in reported cash inflows from operating activities, with a corresponding net increase in financing outflows.
Wait, there's more!
Of greater impact will be a change in managers' behavior as they realize that a main impetus for entering into leases has been better-looking financial statements. Once they are face to face with real truth, maybe they will abandon leasing and just negotiate more efficient purchase prices and interest rates.
Better accounting should lead to better decision-making inside the firm as well as outside. At least we hope so.
Despite these advantages, we expect that FASB will face huge opposition to progress, spurred on by the widespread veritasaphobia (the fear of telling the truth) that infests management ranks. Many, if not most, managers will resist being forced to reveal what they've kept secret for so long. Of course, they will stay blind to the real truth that publishing more complete information will increase their stock price by driving out the uncertainty that depresses it.
They will also utter yelps of dismay at higher compliance costs, because they have to go to the "trouble" of measuring their lease liabilities. Of course, this is no trouble at all, and is something they should already go through before deciding to lease in the first place. Alas, they will miss the fact that reporting more useful information will reduce the analysis costs incurred by statement users, as well as their risk, thus allowing them to pay more for the stock.
Mark our words: The dumbest opposition will surely come in complaints that reformation will destroy the leasing industry. What utter drivel! If the cornerstone of this industry has been off-balance-sheet financing, then its foundation is deceptive reporting. Can anyone tell us why that unethical behavior is worth protecting?
Would it be harder to get financing? Not at all - the same capital is out there and it will be just as available. Further, it will be cheaper, because managers won't be forking over a premium just to look better.
As we see it, it will be good riddance to replace today's leasing industry with a new one that doesn't use deceptive reporting as a marketing tool.
It's well past time to throw out these deficient practices and move financial reporting into the 20th Century. Long gone are the days when institutionalized lying can be tolerated. In fact, SFAS 13 and its spinoff standards actually embraced and encouraged lying. It really is just as simple as that, and it's time to call it what it is, fix it, and move on.
And, no, that wasn't a typographical error: Lease capitalization is a 20th Century accounting method that should have been made the standard 30 years ago. As we'll discuss in our next column, capitalization has its own shortcomings. Specifically, it still focuses on the initial transaction and systematic allocation of cost-based depreciation and interest. Far more useful statements would result from observing and then reporting the whole truth about a lessee's assets and liabilities.
Then and only then will financial accounting live up to its social duty.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at firstname.lastname@example.org.
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