Virtually everybody in America with at least a high school education understands that corporate managers at Enron cheated investors, creditors and even their own employees by creating an organizational architecture with two purposes in mind: enrich themselves and cover up their tracks.
With respect to the accounting, the American public now recognizes that Enron understated its liabilities by billions of dollars. While the Powers Report makes clear that Enron executives broke the accounting rules, many in America wonder about a profession that allows business enterprises to hide their liabilities.
Financial Accounting Standards Board should jump on this Enron moment before it slips away. Perhaps FASB’s definition of a liability is still OK; recall that the board states that, "Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions of events."
Maybe the FASB needs to amend SFAS 6 to state the obvious: that the constitution of a liability doesn’t depend on whether it is owed by the parent company, a subsidiary, a corporate-owned partnership (whether as a general partner or as a limited partner), or comes in the form of those now dreaded special purpose vehicles. Organizational architecture does not dictate whether an item is a liability. (Does anybody remember the dictum "substance over form"?)
More importantly, I suggest that FASB take its own definition more seriously than it ever has before. While there are several possibilities, the easiest topic to tackle seems to be leases. The FASB didn’t follow its own definition of liabilities when it issued SFAS 13, nor in any of the myriad amendments or interpretations or technical bulletins published since then. The board should immediately reconsider this topic and ask whether any ethical person who understands the rudiments of accounting genuinely believes that operating leases do not constitute liabilities merely because they don’t meet one of four criteria specified in SFAS 13.
The board put itself into a corner when it didn’t require the capitalization of all leases. The consequences were predictable: managers manipulate the system and don’t report as many lease obligations as they can get away with. Auditors, in turn, merely tick off whether their clients follow the rules. While the board has tried to salvage the original pronouncement through a series of amendments and interpretations, it never considered the only satisfactory solution of instructing corporations to tell the truth about their lease liabilities.
Consider, for example, the present-day controversy over synthetic leases. Such leases arise from an intricate arrangement between the firm and a lender and frequently involve the creation of a special purpose vehicle. The purposes are simple: get the tax benefits from a capital lease but deceive the investors and creditors by reporting it as an operating lease.
Whatever the complications, a synthetic lease is like most other leases inasmuch as the lessee borrows money and has to repay it. When one looks at the essence of the contract, instead of getting hypnotized by the contorted structural design, he or she observes that a financial duty exists, the obligation is unavoidable and the event obligating the enterprise has occurred. I suggest that accountants and auditors reread SFAC’s 6 and realize that these three characteristics imply that synthetic leases are liabilities.
One news source reported AOL/Time Warner is engaging in a recent $1 billion synthetic lease. Post-Enron, how can anyone defend off-balance sheet accounting for this debt? Executives at AOL/Time Warner could demonstrate leadership and their commitment to truth telling by putting this synthetic lease on its balance sheet. Time will tell whether they are up to the challenge.
I recognize and appreciate the political niceties facing the board. Without support, the FASB would find it very difficult to maneuver and could cut its own throat. But today is different. With mouths agape over Enron’s lack of disclosing billions of dollars in debt, Congress and the investing public will support improvements in the financial model, even if managers do not.
My hope is that board members have the courage to take action while the political climate is favorable. Carpe diem!
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