One dirty little secret of financial reporting is off-balance-sheet financing.

Managers strive after it like the Holy Grail, wanting to take on debt while reporting none or only some of it as liabilities on their balance sheets. They hope that depriving investors and other statement users of vital information will drive their stock price higher. Adding insult to injury, pulling off OBSF almost always means spending a lot of shareholders' money to structure transactions, just to keep those shareholders in the dark.

Ironically, some OBSF is mandatory under generally accepted accounting principles. Although SFAS 158 now puts defined-benefit pension and OPEB liabilities on the employer's balance sheet, it's only the net amount that appears. A closer look at employee options reveals them to be a derivative liability that isn't on the balance sheet, except for a tiny piece that ironically shows up as equity.

Other OBSF occurs haphazardly, especially for convertible securities, because the derivative liability for the holders' call options is mixed in with the reported debt or equity. Finally, other instances of OBSF occur when management policy triggers deficient but otherwise GAAP-compliant accounting. The most common example is operating leases.

Paul Miller's harsh introduction to this type of OBSF came as a young man when he asked Chuck Lyon, a more senior CPA and a good friend, whether his Big Eight firm ever had problems with clients manipulating lease agreements to avoid capitalization. The friend grinned sheepishly and said, "Paul, we help them do it."

What we're going after in this article is the misunderstandings that promote that behavior.

THE GOAL

As near as we can tell, management's goal for OBSF is a better-looking balance sheet with a lower reported debt/equity ratio. To be blunt, managers' pursuit of OBSF is nothing but creating deliberately misleading financial statements. We don't care if it can be done within GAAP. This defense is unacceptable, because other available choices don't mislead. At a minimum, management should provide enough supplemental information to overcome the standards' flaws.

PREMISES, PREMISES

We think these premises lie behind managers' reasoning:

* There is no problem, ethical or otherwise, in knowingly presenting false or misleading information.

* Market participants blithely use GAAP statement information without question.

* The market does not penalize deception, even when it's obvious.

* Only the balance sheet is affected by OBSF.

EMPTY PREMISES

As a matter of fact, each premise is faulty:

* Fraud is the act of not telling the truth in order to entice others to make decisions they would not make if they knew the truth; thus, OBSF is tacitly unethical and illegal. In addition, it chokes off the flow of useful information to the markets.

* Wise analysts wrestle with GAAP statements to extract what truth they can; even so, they are left with boatloads of uncertainty, high costs and resentment toward management.

* When users face uncertainty, they spend money and expend effort gathering information, trying to deal with it and overcome their distrust for management. Bottom line, they impose penalties in the form of higher capital costs and lower security prices.

* All other financial statements can be negatively impacted by OBSF.

'HOLEY PAIL'

If managers expect buckets of cash to come their way after committing legal fraud, they need to think again. Indeed, their Holy Grail is really a "holey pail" that can never hold water. By flaunting their guile, they destroy their credibility, costing them far more than they can ever hope to gain by deception.

Apart from that bit of justice from the market, we're about to show that the present GAAP treatment for operating leases seriously deforms all three financial statements to the point that they're unsuitable for use without extensive modification.

ABERCROMBIE & FITCH

We recently studied the 10-K filed by Abercrombie & Fitch on March 30, 2007. On page 43, management unflinchingly proclaims, "The Company does not have any off-balance-sheet arrangements or debt obligations." Yet not a half-inch further down the page is a schedule that reports $1.7 billion of "operating lease obligations." Either they are grossly ignorant of the simple truth that operating leases create OBSF, or they thought no one would notice their flat-out misrepresentation. The same holds for the auditors and lawyers who looked over these words. We cannot imagine what they were thinking.

Like other statement users, we had to comb through the report and make assumptions to fill in missing facts. We produced these estimates: lease liability (discounted at 8 percent), $1.3 billion; leased assets (by default, same as the liability), $1.3 billion; annual lease interest expense, $100 million; annual depreciation (assumed seven-year life), $180 million.

We also gleaned the following reported data: total assets, $2.2 billion; total liabilities, $840 million; net income, $420 million; rent expense, $220 million; cash from operations, $582 million; tax rate 37 percent. We combined these numbers to produce several statistics to contrast the bogus numbers produced under OBSF against what we think would have been reported if the leases had been capitalized. The results are in the accompanying table. (See "Patching the Pail," below.)

ANALYSIS

The question is not whether OBSF makes ANF look better or worse than it would look if capitalization occurred. Rather, we ponder whether OBSF confounds the financial statement message so badly that it leads to poor decisions, both internally and in the markets. How can this outcome be anything but bad news for managers, employees, shareholders, the markets as a whole, and the economy?

Our numbers for ANF quite clearly show deleterious multiple impacts. By adding the omitted lease liability to the reported liabilities, we estimated the debt/equity ratio to be 1.5, instead of 0.6. By replacing rent expense with estimated lease interest and depreciation expenses, the modified net income fell 10 percent below the GAAP earnings. When we divided the modified earnings by the modified measure of total assets, the estimated ROA dropped from 19 percent to only 11 percent. (Of course, both measures are spurious because of other flaws in the reported income and the assets' book values.)

If the leases had been capitalized, the only lease-related cash outflow for operations would have been for interest, with the remainder of the "rent" payment being reported as a financing use that reduced debt principal. When we made that modification, cash from operations jumped to about $700 million, more than 20 percent greater than the reported $582 million. Finally, replacing the reported rent expense with interest and depreciation increased the estimated EBITDA by more than 25 percent.

The answer is quite clear: Abercrombie's Holy Grail of OBSF is indeed a holey pail. Management's pursuit of a lower debt/equity ratio produces all sorts of problems throughout the statements and contaminates every decision based on their contents.

OPTIONS, ANYONE?

Earlier, we mentioned employee options as another form of OBSF, because they create an unrecognized derivative liability equal to their fair value. On page 68 of its 10-K, ANF discloses its options' intrinsic value as $375 million, a measure that is surely less than fair value.

We then recalculated the debt/equity ratio after first adding this amount to the modified total liabilities, and then subtracting it from equity because it is an unreported expense. Even with this low valuation, the ratio climbs to 2.4, a far cry from the apparent 0.6 value based on GAAP.

WHAT'S THE REMEDY?

Three things must be done to stop this nonsense. The first is education: Managers must confront reality so they'll stop pursuing OBSF strategies. In the same vein, auditors must learn to stop enabling their clients' self-destructive behavior. The second is regulation: We desperately need new standards that do away with OBSF, and quickly. And the third is augmentation: Managers should ensure that the markets have better information by voluntarily providing full and fair disclosure of the effects of bad GAAP.

Just in case someone might think we're concerned with a minor problem, a report from the chief accountant of the Securities and Exchange Commission estimated that the combined uncapitalized future cash flows for operating leases was about $1.25 trillion last year for all public U.S. companies.

A DISCLAIMER

We acknowledge that our modifications for ANF may not be accurate; however, we disclaim responsibility for any inaccuracies. The blame lies with management for engaging in OBSF in the first place, and not providing enough supplemental information to allow users to overcome the havoc wreaked on their statements by this misleading financial accounting policy.

The real consequence of their search for the Holy Grail of reporting less debt is surely less wealth in the hands of the shareholders, not more. Lots of money is leaking out of holey pails, and it's about time everyone admitted that this accounting version of the shell game doesn't do anyone any good.

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 paulandpaul@qfr.biz.

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